All companies have common stock. For many companies, that may be the only class of stock. However, when the time comes to bring in outside financial investors, the most common class of stock to issue is preferred stock. The use of preferred stock provides several benefits to investors, which make the investment more attractive, and presents both advantages and disadvantages to holders of common stock.
The Benefits of Preferred Stock for Investors
One of the benefits of using preferred stock is that it allows a large degree of flexibility in negotiating financing terms with investors. As a result, preferred stock can be issued with a wide variety of features. One very common financial benefit provided by preferred stock is a liquidation preference, in which the preferred stock is paid back first in the event of a sale of the company. This preferential return may be limited to the amount originally paid, or may give the investor a right to a premium. Either way, the preferred return provides the investors with downside protection and the potential for a favorable return that increases the price they are willing to pay.
Another appealing term often found in preferred stock is a degree of voting control. Because the preferred stock is issued as a separate class from the common stock, it’s possible to provide the holders of preferred stock the ability to vote as a separate group on company matters. It’s common to see preferred stockholders have the right to block future financings or sales of the company.
The Impacts of Preferred Stock for Common Stockholders
The impact of issuing preferred stock on the company’s common stockholders is mixed, however. On one hand, by creating a senior class of stock with superior economic rights, the common stockholders lose some of the financial return they may otherwise have in the event of the sale of the company. They also may provide a subset of the stockholders who own a minority of the company overall have significant control over the company’s future.
Because of these rights and benefits, the preferred stock is clearly more valuable per share than the common stock, which provides a company with certain significant advantages. Primarily, it means that the preferred stock can be sold at a higher price, which reduces dilution to the holders of the common stock. That price differential also allows an investor backed company to continue to issue stock options to service providers at a price that is heavily discounted to the price paid by the investors for the preferred stock. This discount can provide a valuable employee recruiting and retention benefit that is otherwise unavailable.
It’s also important not to overstate the downside of the control and voting provisions often requested by holders of the preferred stock. With or without explicit voting control in a separate class of stock, a stockholder holding even 5% of the company’s stock will possess significant leverage in, and as a practical matter may be able to block, future transactions. In addition, should the company ever go public, the preferential economic rights will typically not apply, and most of the control rights will be eliminated, leaving the preferred stockholders and common stockholders in the same position.
Inceptiv Law
Inceptiv Law possesses an extensive background in investor-backed companies across many industries. We understand the significant challenges and unique issues that arise when growing an investor-backed company, and Inceptiv Law has the experience to navigate you through them. Contact us to schedule your consultation.
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