Congratulations. You have convinced several angel investors to fund your startup. Do the angels get common stock or preferred stock? What’s the difference between common and preferred stock? Why does it matter? This deal term has implications for future funding rounds and your relationship with the angel investors and venture capitalists.
Common Stock versus Preferred Stock: The Liquidation Preference
Common stock gives the holder an equity ownership position in the company, voting rights, and sometimes dividend rights. Preferred stock also gives the the holder an equity ownership stake, with additional rights that common stock does not possess as discussed below.
One big difference between common and preferred is that preferred stock enjoys a liquidation preference. The preferred has the right to receive a payment prior to distributions to the common stockholders when a liquidation or sale of the company occurs. This payment is usually a multiple (e.g., 2X) of the stock’s issuing price. To put the founders on the same footing as the investors in the case of liquidating distributions, founders usually prefer to issue common stock to angel investors.
There’s another benefit to issuing common stock. Issuing common stock rather than preferred stock produces a simpler capital structure with only one class of stock outstanding. One benefit is that the company can continue to make the S corporation election because it has only one class of outstanding stock.
Despite these benefits, founders are not always in a position to issue common rather than preferred stock. Angels from an organized syndicate, such as Band of Angels or Kereitsu Forum, are more likely to push hard for preferred. The attractiveness of the company plays a big role in how the negotiations will proceed. The type of stock issued is a point of negotiation.
How The Common or Preferred Stock Choice Affects Your Company’s Future
In addition to the liquidation preference, preferred stock holders have other rights. Here are four of the most important ones.
- Preferred stock often contains a conversion option. This means that the preferred holder can convert their preferred to common according to a given ratio. The most common ratio at the time of issuance is one to one, though the ratio will change with additional rounds of financing.
- Preferred stock usually contains an antidilution provision that is triggered if the company issues shares below the conversion price. An antidilution provision discourages the company from reducing the share price in future financing rounds. How the conversion price is calculated depends on the type of antidilution protection. Full ratchet protection (favorable to preferred stock holders) and weighted average protection (favorable to the company) are the most common types of antidilution protection.
- Preferred stock sometimes has dividend rights. The dividend can guarantee a certain annual return on the original purchase price. In a liquidation event, dividends may have to be paid out to the preferred before the common gets paid anything.
- Preferred stock may contain blocking rights. Blocking rights allow the preferred to stop a sale of the company, an equity financing, or increase in the number of stock options. Further, in some cases blocking rights events to corporate governance issues like the appointment of senior executives.
Conclusion
This brief discussion should underscore that preferred stock holders can substantially influence your company’s operation. Keep in mind that if you give angel investors certain rights in one financing round, that will establish the baseline for negotiating rights with angel investors or venture capitalists in the next round. You cannot expect to give fewer rights than you have to a prior investor.
You cannot expect to issue only common stock for more than one or two rounds. Many angels, and certainly VCs, will expect and demand preferred. The important thing is to understand the effects of issuing common or preferred.
Douglas Y. Park
Twitter: @DougYPark
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