For typical venture-backed Delaware corporations, the founders and employees customarily receive equity in the company in the form of common stock, whereas outside investors typically receive equity in the form of preferred stock. As implied by the name, holders of preferred stock have certain preferences and rights that the holders of common stock do not have. While all of these rights may not be included in every financing, in most cases these rights are customary and expected by investors. Here are ten things you should know about preferred stock rights, and notes on terms that are often subject to negotiation.
- Liquidation Preference
One of the most important preferences that preferred stock has over common stock is a “liquidation preference.” Currently, the most common type of liquidation preference is referred to as “non-participating” preferred, which allows the holders of preferred stock to choose to either receive a distribution of proceeds in a sale or liquidation of the company prior to the holders of common stock, or convert the preferred stock into common and receive proceeds alongside other common stockholders on a pro-rata basis. The other type of liquidation preference is referred to as “participating” preferred, in which the holder of the preferred stock would get the benefit of both getting a distribution of the liquidation preference ahead of common stockholders, AND also getting a distribution alongside common stockholders on a pro-rata basis.
Regardless of the type, a liquidation preference is important to investors as it provides some level of downside protection, especially in situations where the proceeds from the sale or liquidation of a company is roughly the same, or less, than the total amounts invested by investors in a company.
The liquidation preference is generally based off of the amount actually paid for a share of the preferred. Assuming a typical “1X” liquidation preference, then each share would have a liquidation preference equal to the amount invested; in the case of a “2X” liquidation preference, each share of preferred would have a liquidation preference equal to two times the amount invested.
Over the last few years, most West Coast venture capital term sheets have provided for 1X, non-participating preferred. While that is still generally the norm, in some cases investors have insisted on liquidation preferences greater than 1X, or participating preferred, especially for companies that are in distress where the investors have more leverage.
- Anti-dilution Protection
In addition to the liquidation preference, another important right that holders of preferred stock have is anti-dilution protection. These provisions are typically included in the company’s certificate of incorporation, and provide for specific adjustments to the conversion price of preferred stock in the event of certain enumerated dilutive events, to help compensate for such dilutive events.
One common misconception of such anti-dilution protection is that it kicks in any situation where the investors are diluted (eg any additional issuance of shares or increase in the fully diluted share count which results in a reduction in the investors overall percentage ownership in a company). That is NOT the case.
The specific anti-dilutive event addressed by most protective provisions is a situation in which there is an issuance of preferred shares of the company at a purchase price that is less than what the investor previously paid.
Note that there are many exclusions to this anti-dilution protection – a company’s issuance of common stock or options, even if at a strike price less than what the investor paid, is typically treated as an exception or exclusion from anti-dilution protection. There are also many other common exceptions for issuances such as warrants in conjunction with a bank loan, etc.
In addition, to the extent investors may have paid different prices at different times for a company’s stock, whether or not anti-dilution kicks in will be dependent on the price of the new issuance relative to the prior issuances, and such calculation can get complicated.
Finally, how the adjustment to the conversion price of the affected preferred stock is calculated in a dilutive event is based on a formula, the most common of which in West Coast venture deals is a broad-based, weighted average formula which is generally seen as the most favorable to the founders and employees of a company. This is a calculation that takes into account multiple variables, including the number of existing shares, the amount of prior money raised, the number of new shares being issued and the amount of new money raised, to calculate a decrease in the conversion price of the affected existing preferred stock that partially (but not completely) compensates for such dilutive issuance.
Other anti-dilution formulas also exist, the least favorable of which to the founders and employees of a company is a “full ratchet” anti-dilution formula. In a full ratchet anti-dilution adjustment, the existing investors would be entitled to change their conversion price down to the lowest price paid in the dilutive issuance. This adjustment is potentially highly dilutive to founders and also difficult to manage for new investors looking to invest in a down round, as the full ratchet mechanism may preclude the new investors from purchasing a certain target percentage of the company. Given the difficulty companies may have raising money in a “down round” scenario, full ratchet anti-dilution provisions are less common.
- Conversion Rights
As noted above, preferred stock generally has a right to convert, at the option of the holder, into common stock. Given the various preferences and rights of preferred stock, it’s not usual for preferred stockholders to voluntarily convert their preferred stock into common stock except in certain circumstances, such as a liquidity event where it is economically more favorable for the holder of preferred stock to convert into common stock.
In many cases, the conversion of preferred stock is automatic. In the typical certificate of incorporation of a company, there are provisions in which, upon approval of a requisite threshold of stockholders or in connection with an IPO, all preferred stock is forced to convert into common.
- Dividends
Preferred stock typically is entitled to priority in the payment of dividends over common stock, and most certificates of incorporation will also specify a specific dividend rate (expressed as a percentage of the original purchase price of the preferred shares).
However, it is very rare for venture-backed private companies to pay a dividend to investors, as most such companies are not profitable, and so their investors would prefer they use funds to invest in the growth of the companies (the entire reason why they invested in the first place!). Moreover, even if profitable, some VC fund investors are unable to accept cash dividends for tax reasons, particularly where their fund investors (often referred to as limited partners or “LPs”) are located outside of the US and want to avoid receiving US-based cash profits (referred to as unrelated business tax income or “UBTI”).
Typically, dividends are only payable when declared (and typically never declared) so this difference between common and preferred stock isn’t that relevant for most companies. Finally, there is a distinction between “cumulative” and “non-cumulative” dividends. “Cumulative” dividends will continue to accrue, even if not declared and paid by the company. Over time cumulative dividends can potentially compound and become very large – as a result it’s typical for venture-backed private companies to NOT provide for cumulative dividends.
- Approval Rights & Protective provisions
In a standard priced-round financing investors are typically granted certain approval rights or “protective provisions.”
Most of these provisions relate to actions that a company cannot take (such as taking on debt, issuing new shares, etc.) without seeking approval of some threshold of preferred shareholders.
Many of these provisions are fairly common and typically agreed to by most companies including the right for preferred investors to separately approve actions such as:
- Amending the Company’s Certificate of Incorporation
- Creating a new class of shares
- Increasing or decreasing the number of authorized shares
- Amending or changing the rights of any class of shares, including the preferred
- Changing the board size
- Incurring debt above a certain limit
- Approving a merger or sale of the company
Most of these protective provisions relate to major events in the “life” of a company, such as financings and exits, so it’s reasonable to expect outside investors to have a say in these events. However, there are nuances to how such provisions are drafted, and we always recommend having counsel review such provisions, especially at the term sheet phase where there is often more room to negotiate such provisions.
- Preferred Series Classes; Shadow Series
When a company closes its first priced round financing (typically a Series Seed or Series A Preferred round), the company typically only has one series of preferred stock.
After multiple rounds of financings, a company can generally expect to have more than one series of preferred — one series for each round of financing closed (e.g. if there has been a Series A financing, and then a Series B financing round, a company would expect to have both a class of Series A Preferred Stock and a class of Series B Preferred Stock).
While these different series of preferred stock usually have similar rights to each other (other than the liquidation preference for each class), that is not always the case. One series may have specific class votes or blocks (as further explained below) or may have other different rights.
In addition, even if the series are generally treated the same, it is not unusual for each series to have the right to elect their own director (e.g. a Series A director appointed by the holders of Series A Preferred Stock, and a separate Series B Director appointed by the holders of Series B Preferred Stock).
In addition to separate classes of Preferred Stock, to the extent there are outstanding SAFEs or convertible notes, then the conversion of such outstanding SAFEs or notes at the financing may result in a “shadow” series of preferred. These “shadow” series generally have the exact same rights as the “non-shadow” series of preferred sold to new investors in the financing round in which they convert.
However, because the SAFEs or notes may have converted at a different (usually lower) price per share than the price paid by cash investors in the round (usually due to a valuation cap or discount), such shares should have a different liquidation preference, and thus are identified as a separate series of stock in the company’s certificate of incorporation. Thus, you may see a class of “Series A-1 Preferred” shares sold, along with the issuance of “Series A-2 Preferred” and/or additional series above A-2 (depending on the number of SAFEs/Notes with different conversion prices)
- Voting & Blocks
While preferred stockholders as a whole may have approval rights, in addition to “what” types of approval rights preferred stockholders may have, just as important is determining “how” such approval rights or protective provisions are voted upon in situations where a company has more than one series of preferred stock.
From a founder/company perspective, ideally all series of preferred stock will vote together and approve matters together, as a single class on a pari-passu basis (e.g. on an equal basis). In other words, in order to get approval of the preferred shareholders on an approval right or to waive a protective provision, you need only get a majority (or the applicable threshold) of all of the preferred shareholders to get such approval or waiver.
Alternatively, if each series of preferred stock gets their own approval right or voting right, then the company must seek the approval of each series of preferred stock separately (e.g. a majority of each series of preferred stock), which provides each series of preferred stock with a separate blocking right. Given that not all series of investors are similarly situated, this may give rise to issues in getting certain actions approved (for instance, later investors, who have paid more per share than earlier investors, may be less inclined to approve a merger or acquisition if they feel the price is too low).
Therefore, it’s generally to the benefit of the founder/company to avoid allowing for separate series votes or approvals, and have all series vote together on a pari-passu basis.
Finally, as alluded to earlier, the approval thresholds matter – generally speaking most approval rights require the approval of holders of at least a majority of the applicable preferred shares approving or waiving such right. However, higher thresholds may be requested by investors looking to have individual blocking rights or greater minority protections.
- Board Seats
For a given financing round, investors in that round (e.g. the “Seed” or “Series A investors”) usually ask for a board seat to be appointed by investors of that particular round/class of shares. Often that seat will be designated by the lead investor for that financing round.
These rights are typically codified in both the company’s certificate of incorporation and in a separate standalone voting agreement between the companies and the investors.
Founders should expect that investors of each round (e.g. the Series B, Series C, etc.) will also ask for their own board representative. As such, it’s possible that founders (who typically also hold board seats) may find themselves out numbered or outvoted unless they plan accordingly.
For that reason, founders should strongly consider conferring with counsel regarding possible ways to negotiate board provisions and/or potentially structuring the board PRIOR to a financing to ensure the founders retain control of the board. For instance, it may make sense for investors represented in earlier rounds to lose board seats as larger, later stage investors are added.
- Valuation/Price per share (vs Common)
When a company raises a priced round financing, the overall valuation of the company typically determines the price per share paid by the investors for preferred shares issued at that financing. For example, for a company that sold shares of preferred stock at a $100M post-money valuation with 100M shares outstanding fully-diluted post financing, the preferred stock would be sold at $1 per share.
Compared to preferred stock, common stock is typically valued at a significant discount, based on a few factors, including: (a) a discount for lack of marketability (as the common is subject to more restrictions than preferred); (b) discount for lack of control (as the preferred have various approval and blocking rights over common); and (c) additional discounts given the lack of liquidation preference and other preferences enjoyed by the preferred stock over the common. For Seed or Series A stage companies, common stock might be valued as little as 15%-20% of the last preferred stock price.
This determination of value of the common vs the preferred is typically done pursuant to a 3rd party valuation report (commonly referred to as a “409A report”), which determines the fair market value of the common stock of the Company. Thus, for an early-stage company the preferred stock is typically valued and priced at a premium to common stock.
However, as a company gets closer to a liquidity event (whether an IPO or sale of the company) that premium potentially shrinks or disappears, depending on the circumstances and whether the proceeds from such liquidity event exceed the existing liquidation preferences of the preferred investors.
Ideally for founders and employees, in a sale or IPO resulting in proceeds well above the investor’s liquidation preference, the investors will be better off converting into common, in which case the common and preferred will essentially have the same value. However as noted above, in downside scenarios there is a very real risk that the proceeds in a sale will result in some or all of the proceeds going to the preferred stockholders, with little to no distribution going to common holders, such risk reflected in the lower value valuation of common stock in early stage companies.
- Other contractual rights: Pro-rata right/Right of First Offer; Information Rights; Right of First Refusal; Co-Sale Rights; Registration Rights
While the subject of another blog post, preferred investors also typically receive additional rights as investors. These rights typically aren’t “baked in” to the company’s certificate of incorporation, but rather are agreed to via contract pursuant to standard form NVCA (National Venture Capital Association) agreements that provide such customary rights.
These rights typically include:
- Pro rata rights (also known as the right of first offer or preemptive rights),
- Information rights,
- Rights of First Refusal & Co-sale rights imposed on sales by key common stockholders,
- Drag along obligations, and
- Registration rights
Not all preferred investors may receive such rights; and in certain cases such rights are typically reserved for certain investors who meet a certain dollar investment or percentage ownership threshold in the company.
Inceptiv
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