Holders of a company’s common stock should understand the special rights of the holders of the preferred stock that impact the potential return on the common stock.
- Ownership in a company is represented by the shares of stock that the company has issued, which in a startup comprise common stock and preferred stock.
- Founders and employees own common stock, and/or options to acquire common stock, while investors own preferred stock.
- The preferred stock has certain rights that the common stock does not have, of which two of the most important are the liquidation preference and participation rights.
- The liquidation preference means that in a liquidation or sale, the preferred receives their money back before the common receives any distribution.
- The amount that the preferred receive as a priority distribution is typically the amount of their investment (1x), but in a situation where the company cannot easily raise money from investors could be higher than 1x. The higher the liquidation preference of the preferred, the more adversely impacted the common may be, so founders should carefully weigh a capital raise with more than 1x for the preferred against the potential benefits.
- It is most common in venture financings for the preferred to be non-participating, meaning that after the distribution to the preferred, the next distribution is to the common. If the preferred is participating, then after the distribution to the preferred, the preferred “double dip” and additionally share in the distribution to the common in accordance with their percentage ownership.
- At the time of sale or liquidation of the company, the preferred will receive the greater of (i) the liquidation preference, and (ii) the amount they would receive if they converted to common stock (ownership percentage).
- Example: An Investor invests $2,000,000 in a company for a 25% ownership stake represented by preferred stock.
- The example shows that a lower purchase price and a higher liquidation preference results in most of the proceeds being paid to the preferred, although the preferred owns only 25% of the company.
- Accordingly, employees joining a startup should ask questions to understand the liquidation preferences of the preferred stock in assessing the potential value of the common stock.
If you require any further information about preferred stock in a startup or startup investments, please contact Edward Grenville, Managing Shareholder, Inspire Business Law Group, PC (egrenville@inspirelawgroup.com; +415 279 0779; www.inspirelawgroup.com).
This article is provided for educational and informational purposes only and is not intended to be, and should not be construed as, legal advice.
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