By: Benjamin Jacob
First-time founders typically find themselves overloaded with new information to digest and a never-ending to-do list. Legal often leads the way providing confusing and opaque subject matter to digest.
One question that comes up from first-time founders is what is the difference between common stock and preferred stock. Some founders are surprised to learn that founders typically will be issued common stock, not preferred stock. It is valuable for founders to understand early on the differences and the corresponding control and ownership dynamics involved between these two different types of capital stock. This blog post examines the key differences and accompanying dynamics.
For more great content on preferred stock and venture financings, check out our video series VENTURE FINANCING TIPS: PREFERRED STOCK AND VALUATION
COMMON STOCK: ORIGIN + THE BASICS
Common stock is a unit of ownership or equity in a corporation – essentially we use common stock to represent a given person or company’s ownership in a company.
Back in the day (like 400+ years ago ~1602), ship owners seeking to manage their risk and protect their own fortunes sought capital investors to back their ventures, sending their ships out into the world in hopes of returning with riches and goods. In order to do so, limited liability companies (e.g. East India Company) were formed. In order to express and communicate ownership, the term “common stock” came into being to represent what everyone from the ship owner to these early stage venture capitalists owned in the company. A successful expedition’s profit would then be distributed in accordance with the ownership percentages held by each stockholder and denominated in shares of common stock.
Fast forward to today, when a startup is formed, the initial founders will typically be issued common stock – not preferred stock. Employees and advisors also usually receive common stock – typically in the form of an option to purchase common stock. Some companies choose to create different classes of common stock with each class possessing differing voting (control) rights – this is often referred to as a dual-class or multi-class structure. It is unusual that different classes of common stock hold different economic rights but it is possible.
PREFERRED STOCK: ORIGIN + BASICS
Preferred Stock is thus also a unit of ownership in a corporation. A share of preferred stock represents a unit of ownership along with accompanying preferential rights that are often economic in nature.
Historians generally concur that preferred stock first came into use in the United States in the early 1800s as enterprises operating in the transportation industry needed to up the ante to entice investors to invest capital to fund risky infrastructure improvement projects such as railroads.
In today’s world, startups issue preferred stock primarily to investors. “Preferential” or “preferred” refers to the fact that shares of preferred stock bear superior economic and control rights over those that accompany shares of common stock. A startup typically issues preferred stock at its first priced round whether a seed or Series A financing round.
The basis for preferred stock flows from the reality that venture capitalists willing to invest a high-risk asset require greater return, more protection, and more control that would otherwise be granted through shares of common stock.
PREFERED STOCK: KEY FEATURES
Below, I’ve listed a non-exhaustive list of the key features of preferred stock that typically appear on a term sheet for a venture financing.
Liquidation Preference. A liquidation preference essentially means the investor gets paid before anyone else does in the event the business is liquidated whether through an IPO or acquisition/merger. Though market dynamics as of today’s writing are very much in flux after several years of founder-friendly fundraising, market standard for a liquidation preference is 1x. This means the liquidation preference contractually protects the investor’s right to get their money back first.
Board Seat. The lead investor in a venture financing usually acquires at least one board seat in connection with their investment in the company. Depending on the company stage and size of investment, the investor could acquire more than one board seat. This provides the investor with a vote and say on the strategic direction of the company.
Information Rights. Preferred stockholders often negotiate and seek contractual rights to key company information – often financial in nature – in order to keep well-apprised on the state of their investment.
Pro Rata Rights. Pro rata rights give an investor the optional right (not obligation) to maintain their same level of ownership in the company and gives the option for the investor to avoid unwanted dilution of the investor’s equity stake.
Protective Provisions. Protective provisions are rights that give the preferred stockholder the right to veto or block certain corporate decisions. The provisions themselves are negotiated – often in the term sheet and then more fully fleshed out in the financing documents prepared and executed pursuant to a venture financing. This essentially allows a minority stakeholder (i.e., the preferred stockholder) to prevent the Company from taking certain corporate actions such as selling the company, changing its primary line of business, or taking out too much debt.
The differences between common stock and preferred stock is a fundamental legal concept founders must understand. Getting up to speed sooner than later will help founders be prepared by properly understanding the context in which they’ll be raising outside capital. As a founder begins receiving term sheets, it is essential to work with trusted counsel negotiating the rights being granted to incoming investors receiving preferred stock.
Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.