There’s a steep learning curve for first-time startup founders, especially with legal. One of the early sources of confusion I see working with first-time startup founders in Seattle is the difference between common stock and preferred stock.
Common stock does not sound exciting. Preferred stock does. First-time founders are looking for excitement—especially when it comes to their millions of initial shares—and so they’re often surprised to hear that they’ll be receiving common, rather than preferred stock when the startup is incorporated.
More experienced founders may scoff at this. But I actually think it’s a great teaching moment to help the founders understand at a very early stage the ownership and control dynamics they’ll need to navigate in relation to later investors. Let’s take a closer look.
Common Stock Basics
Common stock, like preferred stock, represents a unit of equity in the startup. That unit of equity carries with it certain economic and control rights.
Founders almost always receive common stock. The same is true for employees and consultants, though, to be more precise, most employees and consultants will receive stock options that give them a right to purchase a certain number of shares of common stock at a particular price at some point in the future.
Related: A Short Guide To Issuing Stock Options
There can be more than one class of common stock, but if there is, it’s usually to establish different voting rights, not economic rights. Differing economic rights will usually be reserved for preferred stock.
Preferred Stock Basics
Investors almost always receive preferred stock. As with common stock, preferred stock is a unit of equity in the startup, but with certain superior economic and control rights to common stock.
Most successful, venture-backed startup will have multiple financing rounds. For each round, there will typically be a distinct series of preferred stock tied to the financing series. So, if a startup had raised a Series A and a Series B, then it would likely have Series A Preferred Stock and Series B Preferred Stock.
Key Features of Preferred Stock
Investors willing to pump hundreds of thousands or millions of dollars into your unproven startup expect preferential treatment. And they get it in the form of preferred stock. There are many different features of preferred stock relevant to startup founders; this post highlights several high profile ones, but is not an exhaustive catalog.
A liquidation preference effectively gives investors the right to get paid first. That is, investors get paid before common stockholders, like founders and employees, if there’s a liquidity event, like an acquisition or an IPO.
The typical liquidation preference is 1x, meaning the investor gets back the amount of their investment before the common stockholders see any money. However, if investors stand to receive more than their liquidation preference if they convert to common stock, then you can be sure they will do so if they have the option.
Keep in mind that liquidation preferences can be stacked. So as additional rounds of investment are raised, the liquidation preferences of the preferred shareholders may be ordered such that investors higher up in the stack will be entitled to be paid out before other investors with liquidation preferences, though generally all preferred stock will be paid out at the same time. As usual, common stockholders will be at the bottom of the stack.
Also keep in mind that there's more than one kind of liquidation preference, including non-participating preferred and participating preferred, so make sure you understand what kind of preference is in place and what impact it may have.
Protective provisions give preferred shareholders the ability to block certain decisions, like selling the company, amending the governing documents, declaring a dividend, and other decisions. The common theme here is investors want the ability to block major decisions that could negatively impact their investment. Protective provisions give investors this blocking power by allowing preferred stockholders to vote separately from common stockholders on these issues.
Protective provisions can seem innocuous to first time founders, who may assume that investors wouldn’t do something like block a sale of the company if there’s a big offer on the table. This is a mistaken assumption.
The VC economic model depends on having massive exits by a few of its portfolio companies. An exit that could be life-changing for a founder (e.g., a $50 million acquisition) would not be viewed as a massive exit by most VC firms. And so the investors may have an incentive to block an acquisition like that and push the company to keep growing and achieve a much higher valuation. You can see how this can pit the interests of the founders against their investors.
Investors will likely negotiate a board seat on the startup’s board of directors. This will allow the preferred shareholders to elect one (or more) directors to the board. In effect, this gives the investors a seat at the table and a say in the strategic direction of the startup.
This isn’t necessarily a bad thing for the founders. If you’ve chosen good investors who are eager to provide support beyond just writing checks, having an experienced investor participate in setting the strategic direction for the company can be a huge boon especially for inexperienced founders.
Information rights are what they sound like—they give investors rights to receive certain information from the company, including things like financials, budgets, and the like.
While this can seem relatively harmless, founders should be thoughtful about what information and to whom they grant these rights. Circulating quarterly financial statements to a handful of investors isn’t burdensome, but agreeing to send information upon request to any investor can devolve into administrative whack-a-mole.
Pro Rata Rights
Pro rata rights give investors the right to maintain their ownership percentage in the company. So if, for instance, Series A investors purchased 20% of the company and they had pro rata rights, then in the Series B, they would have an opportunity to purchase a sufficient number of shares to maintain their 20% ownership stake. To be clear, this right doesn’t obligate investors to maintain their ownership percentage, it simply gives them the option to do so.
Anti-dilution rights protect investors’ downside in the event that the startup has a down round. A down round occurs when the company’s valuation is lower than in the previous round. In that scenario, previous investors don’t want to get diluted and so they’ll have insisted on some kind of anti-dilution protection that entitles them to receive more shares when they convert into common stock. There are several types of anti-dilution rights with “broad-based weighted average” being the most common. “Full ratchet” is less common and not founder friendly.
Anti-dilution provisions are some of the more complex founders will encounter and should make sure they’re working closely with counsel when dealing with these.
To reiterate, this post is a primer on the difference between common and preferred stock, with some of the key preferred stock provisions highlighted. But there are many more features of preferred stock for founders to explore in connection with raising a priced round, ideally with the help of a trusted lawyer.