Early stage companies and founders commonly wonder about the difference between common stock and preferred stock. The two are very different forms of equity; preferred stock provides holders many beneficial rights and powers that are not otherwise available to common stockholders. Here are four key differences:
As the name suggests, preferred stock has priority over common stock. In a liquidation, dissolution or sale of a company, preferred stockholders are paid a specified amount of money prior to the holders of common stock.
The liquidation preference of preferred stockholders is one of the most highly negotiated aspects of preferred stock deals.
A liquidation preference may not be relevant if the proceeds from the sale of a company are high and allow for distributions to both preferred and common holders.
However, if the proceeds of a sale are low, or the aggregate liquidation preference is very high, there may not be any sale proceeds to be paid to common holders following payment of the liquidation preference to preferred stockholders.
Upon a liquidation event — usually the sale but sometimes the dissolution of the company — a liquidation preference entitles preferred stockholders to receive proceeds before the common stockholders.
There are two basic types of liquidation preferences preferred stockholders may have — non-participating and participating:
- Non-participating Preferred – Upon a liquidation, the preferred stockholder receives the greater of the purchase price paid for the preferred stock (or occasionally a multiple of such amount) plus accrued dividends (if any) and any other declared but unpaid dividends OR the amount the preferred stockholder would have received if their shares of preferred stock were converted into common stock (e. the preferred stockholder would receive the pro rata portion of the sale price associated with their common stock holding). For example, if preferred stockholders paid $10 million for preferred stock that represents 25% of a company subsequently sold for $100 million, the preferred stockholders would be entitled to an aggregate of $10 million in liquidation preferences (assuming no multiple and no dividends). However, instead of receiving this liquidation preference, the stockholder would instead receive $25 million (25% of $100 million).
- Participating Preferred – Participating preferred stock is subdivided further into full participating and capped participating:
- Participating preferred with no cap: Holders of participating preferred stock with no cap receive both their liquidation preference and the amount they would have received had their preferred stock been converted to common stock. In the above example, the preferred stockholders would receive $32.5 million ($10 million of liquidation preference plus 25% of the remaining $90 million).
- Participating preferred with cap: Holders of participating preferred stock with a cap receive both their liquidation preference and the amount they would have received had their preferred stock been converted to common stock, but only up to a negotiated maximum amount (usually 2-3 times the original purchase price). If this maximum amount is hit, the preferred stockholder receives the greater of the cap OR the amount they would have received had their preferred stock been converted to common stock. In the above example, if the participation cap were 3X, then the preferred stockholders would receive $30 million instead of the $32.5 million they would otherwise receive in an uncapped scenario.
Companies generally hope to negotiate for non-participating preferred stock, which as described above, provides for the greatest likelihood distributions will be available for the common stockholders (typically founders and employees). Companies especially want to seek to establish non-participating preferred stock in their first round of financing. If a company loses this negotiation in its first round, future investors likely will also insist that their preferred stock carry participation rights. As the company raises more money, additional series of participating preferred stock will decrease the likelihood that common stockholders will receive meaningful proceeds in a sale. Such onerous liquidation preference structures can hamper a company’s ability to recruit, retain or motivate key members of management.
Venture-backed companies rarely declare cash dividends while the company is private. However, preferred stockholders may negotiate for dividends in connection with their preferred stock. These dividends typically accrue on a share of preferred stock based upon a percentage (typically 5-9%) of the purchase price for the preferred stock, similar to interest on a loan. While these dividends accrue over time, they are for the most part only paid out in connection with a liquidation event such as a sale or a redemption of the preferred stock. A compounding dividend is even more beneficial to an investor because it is calculated taking into account all prior accrued and unpaid dividends. While preferred stock that carries accruing dividends usually generates a less onerous impact on common stockholders than participating preferred stock , companies still seek to avoid agreeing to accruing dividends as part of a financing because over time it will decrease the amount of proceeds available to common stockholders.
Preferred stockholders typically negotiate for the following rights intended to influence transactions or other matters that require board or stockholder approvals:
- Board Composition
The composition of the board of directors post-financing is almost always a highly negotiated term. Because the board of directors oversees management and determines the company’s major strategic decisions, control of the board is important to both investors and founders.
In connection with a preferred stock financing, the lead investor typically seeks to obtain one or more board seats that will be elected by only the holders of preferred stock. This right typically is implemented in the company’s certificate of incorporation. The investors will often require that the company and its stockholders execute a voting agreement, which further provides that a specific investor has the right to designate the individual that will represent the holders of preferred stock on the board of directors. Common stockholders continue to be represented on a board of directors following a financing; however, depending on the number of board seats that preferred investors demand, founders may find that they no longer control the company’s board of directors following the first or second round of financing.
- Protective Provisions
Preferred stockholders often negotiate for protective provisions, which are provisions in the company’s certificate of incorporation that require certain decisions or transactions can only be approved by a certain percentage of the holders of the preferred stock, voting alone. These preferred stockholder votes typically cover transactions that already require approval of all stockholders, such as a sale of the company or amendments to the company’s certificate of incorporation. In many cases, however, protective provisions also require approval of transactions that do not otherwise require stockholder approval, such as the incurrence of debt, new rounds of financing and increasing the size of the board of directors. These provisions effectively give preferred stockholders significant control over major corporate decisions even if, as a class, they own less than a majority of the company’s outstanding shares.
In connection with the purchase of preferred stock, investors usually negotiate for additional rights and privileges that are not extended to common stockholders:
- Conversion – Preferred stock is almost always convertible into common stock. Typically, preferred stock is convertible at any time into common stock at the option of its holder, and automatically convertible into common stock in certain situations, such as an IPO or upon a vote of a certain threshold of preferred stockholders. The number of shares into which a share of preferred stock is convertible is usually determined by dividing its purchase price by a conversion price. Initially, the conversion price is the same as the purchase price (such that one share of preferred stock converts into one share of common stock), but is subject to change under certain circumstances (as described below).
- Anti-dilution Protection – Anti-dilution provisions are found in a company’s certificate of incorporation and are intended to protect preferred stockholders from dilution when the company issues additional shares of stock at a price per share less than the price paid by the investors. If triggered, anti-dilution provisions will reduce the conversion price of the series of preferred stock affected, with the result that the conversion rate of the preferred stock into common stock will be higher going forward. For example, a share of preferred stock that previously converted into one share of common stock might convert into 1.25 shares of common stock following the effect of an anti-dilution adjustment. Anti-dilution provisions come in two forms: (i) full ratchet, which simply reduces the conversion price of the existing preferred stock to the price of the stock being sold in the financing, and (ii) weighted-average, which adjusts the conversion price of preferred stock based on a calculation that considers both the price of the new shares being issued and the number of shares being issued. Full ratchet provisions are very punitive and rarely seen.
- Registration Rights – When a company issues securities, it must either register the shares being sold or rely on an exemption from such registration. Private companies typically rely on an exemption from registration, so investors hold unregistered securities that are subject to restrictions and/or limitations on resale. Investors, therefore, typically negotiate for certain registration rights that will require the company to register the investors’ shares at a future point in time in order to facilitate future resales. “Demand registration rights” allow investors — after a certain time period and under certain circumstances — to force the company to register their shares on a registration statement, whether or not the company is planning to register shares for a financing or any other purpose. “Piggyback rights” are similar, but less onerous and simply provide that if the company is planning to register shares for an offering (such as an IPO), the investors will have the right to register all or a portion of their shares at the same time.
- Preemptive Rights – Preemptive rights entitle investors to participate in future financings by providing them with a right to purchase some (and occasionally all) of the securities the company proposes to sell. The number of shares an investor may purchase in the proposed financing is usually based on either the investor’s percentage ownership of the company on a fully diluted basis, or, in some case, the investor’s percentage ownership of outstanding preferred stock.
- Right of First Refusal – A founder or other significant holder may, from time to time, have the opportunity to sell his or her common shares, even while the company is still private. If such a common stockholder proposes to sell shares to a buyer (which may or may not already hold stock in the company), rights of first refusal provide preferred stockholders with the right to buy all or a portion of the shares the common stockholder proposes to sell, as long as the preferred stockholder matches the price and other material terms the other proposed buyer offered.
- Co-sale Rights – If a preferred stockholder does not wish to purchase any shares proposed to be sold to a potential buyer, rights of co-sale provide preferred stockholders with the right to participate in the sale of shares by the common stockholder. In this situation, either the proposed buyer chooses to purchase all of the shares proposed to be sold by both the common stockholder and the preferred stockholder, or the number of shares the common stockholder may sell to the proposed buyer is reduced in order to provide for the sale of shares by the preferred stockholder.
- Covenants – As part of the financing, a company typically is required to commit to certain ongoing covenants following the closing, which may include:
- Information rights, which require the company to deliver to investors ongoing financial information, capitalization tables, budgets and related information
- Obtaining insurance, such as director & officer insurance (particularly if an investor is represented on the board of directors) and/or key man life insurance on the lives of founders or other key employees
- Agreeing to hold a certain number of board meetings each year and establishing subcommittees of the board of directors
- Obtaining invention and non-disclosure agreements from all future employees and consultants of the company
- Drag-along Rights – These rights typically are found in a voting agreement and are intended to facilitate a sale of the company. These rights provide that if certain groups approve a sale of the company — typically the board of directors of the company and a certain percentage of preferred stockholders — then all stockholders who are party to the voting agreement must also vote their shares in favor of the proposed transaction. If triggered, these rights ensure that the company is able to obtain not only all the votes required under Delaware law to approve an acquisition such as a merger, but also any higher voting threshold that a buyer may insist the company obtain prior to closing.
As these four elements illustrate, the differences between preferred and common stock can have material and potentially mission-critical implications for a company. Founders should understand the full implications of preferred stock before granting them in any financing, but especially the first round of financing.