Financing your startup is easily one of the most important steps in the process of developing your company—but is it also one of the most despised. When it comes to financing, you’re looking at several rounds, ranging from the very beginning when you’re just getting money from friends and family members who want to help you out from the kindness of their hearts all the way to the IPO and taking your company public. Through it all, though, there are three main ways to structure your company’s financing. Common Stock, Preferred Stork, and Convertible Notes. While this article is limited to a discussion of common stock and preferred stock, each type of equity financing has its own benefits and drawbacks, and hopefully this article will help you understand exactly what the differences are between the two stock classes and how each is used.
Common Stock for Startups
Of the three types of equity financing discussed in this article, common stock is probably the one you’re most likely familiar with. When you form a corporation at the beginning of a venture, this is most likely the stock you’re issuing to yourself and your cofounders. This type of stock is used throughout the early stages of fundraising, and is mostly given to the friends and family members who have helped you out when you’re just getting started.
From your perspective, this is the best type of equity to give to investors. It keeps everyone on the same playing field in terms of voting rights and special privileges, and you don’t have to worry (as much) about running afoul of some securities law by issuing something other than the common stock you started with. It’s the perfect way to get smaller investments from a larger number of individuals in a Kickstarter, crowdfunded kind of way. In short, if all investors are given common stock, everyone has the same rights, and that usually means the founders get to keep control over the company they built.
However, investors do not share the same perspective you do as the founder of your company. Investors are putting large amounts of their money on the line in hopes they’ll see some big profits in the future—and that’s why they hate common stock. When an investor comes calling, they want to have more control over the way the company is run, and common stock simply doesn’t grant them the ability to run the business in a way they’ve determined is the most prudent manner. Ultimately, because the investor will be negotiating with you at a time when your company needs the money, they’re going to have all of the leverage and you’re going to have to give up and accept you’re going to have to give them a class of stock better than common.
Preferred Stock for Startups
And that’s where preferred stock comes in. Preferred stock doesn’t really do much for the company itself, but means the world to the investors because of all of the additional bells and whistles that come attached to the stock to help increase investors’ reward while decreasing their risk. The main factor is that most of the preferences and rights associated with preferred stock go into effect at the time of a liquidation event—often purchase of the company, merger, public offering, or closure.
When it comes to preferred stock, all are not created equal. There are a number of different features that separate one class of preferred stock from another. It is important to keep in mind that a company’s preferred stock may have one of the following additional rights or all of the following rights—it really just depends on how well negotiations went and who the company has as its investors.
Conversion Rights: These are rights given to an investor designed to protect that investor from having her shares diluted by future financing rounds. After all, as more shares are issued, the fixed number of shares an early investor purchased becomes a lower overall percentage of the company’s equity. Generally, what happens with conversion rights is the investor is given the right to convert each share of their preferred stock into a larger number of shares of common stock.
Dividend Preference: While finding a dividend-paying startup is like discovering a dodo on your front lawn, dividend rights ensure a preferred stockholder gets their dividends before anyone else does—even if they have to wait years. The key here is some investors require dividends accrue even if they’ve not been officially declared by the board of directors. If this is the case, the dividends, which should have been paid out on a regular basis, grow in the background and are then paid to the preferred stockholder at the time of a liquidation event, thereby increasing the money made by the investor beyond just an increase in value of her stock.
Liquidation Preference: What happens with a liquidation preference is the investor gets her investment back before any of the common stockholders get a dime. These are triggered by any liquidation event (liquidity event). Something to look out for are liquidation preferences that provide a return on 1x the amount invested, though that’s a topic for another post.
Redemption Rights: The redemption right gives the preferred stockholder the right to force the company to repurchase its preferred shares. Generally, these are only activated after a specified amount of time and, for the most part, most redemption rights go completely unused—particularly in early investment rounds.
Voting Rights: Now here’s a big right for preferred stockholders that can mean a lot of different things. Voting rights can range from the ability to have the investor installed on the board of directors. They can also mean that each vote from a preferred share is worth more than that of a common share. Or, there can be protective provisions in place that give the investor the right to veto certain decisions made on the company’s behalf. Needless to say, the voting rights of a preferred stockholder are far beyond those of a common stockholder.
And those are the most common preferences and rights of preferred stock. Whenever you seek investor financing, always, and I mean always, consult with a startup lawyer to read the terms provided by the investor and help negotiate the deal.
Photo courtesy: Robert S. Donovan