Today on MBA Mondays Startup Financing Options series. we are going to talk about the financing option that I specialize in – preferred stock.
Almost all venture capital firms and many angel and seed investors will require the company they are investing in to issue them preferred stock. The vast majority of equity dollars invested in startups are securitized with preferred stock. So if you are an entrepreneur, it makes sense to understand preferred stock and what it means for you and your company.
Preferred stock is a class of stock that provides certain rights, privileges, and preferences to investors. Compared to common stock, which is normally held by the founders, it is a superior security.
Preferred stock takes its name from a critical feature of preferred stock called liquidation preference. Liquidation preference means that in a sale (or liquidation) of the company, the preferred stock holders will have the option of taking their cost out or sharing in the proceeds with the founders as common stock holders. What this means is that if the value of the sale of the company is below the valuation the preferred investors paid, then they will get their money back. If the sale is for more than the valuation the preferred investors paid, then they will get the percentage of the company they own. I'm not going to go into all the reasons for this as I've done a number of times on this blog already. Suffice it to say that this is an important term for investors, including me.
There are variations of the liquidation preference that give the feature a bad name. Investors will sometimes ask for a multiple of their investment as a preference. Or investors will ask for their preference plus the common interest (called a participating preferred). Our firm is not a fan of these "enhanced preferreds" but we do sometimes get them, particularly the participating preferred, when we join a syndicate where that security already exists. One thing to know about terms around liquidation preference is whatever you agree to with one set of investors, that will be what all the future investors will want because they will not want other investors in the cap table with a preferred position to them.
There are a number of important rights and privileges that investors secure via a preferred stock purchase, including a right to a board seat, information rights, a right to participate
in future rounds to protect their ownership percentage (called a pro-rata right), a right to purchase any common stock that might come onto the market (called a right of first refusal), a right to participate alongside any common stock that might get sold (called a co-sale right), and an adjustment in the purchase price to reflect sales of stock at lower prices (called an anti-dilution right). I'm not going to explain all of these in detail because Brad Feld and Jason Mendelson did an excellent series of posts on all of these provisions which I recommend highly.
Like many things in life, there are many variations of preferred stock transactions, from the relatively benign to the ridiculously painful. I've come to the conclusion that VCs should specialize in the relatively benign because entrepreneurs have long memories and the VCs who specialize in the ridiculously painful will not get to work with the best entrepreneurs and the best deals over time.
There have been a number of attempts to specify what a "standard preferred stock deal" should look like. There is the NVCA standard set of terms and docs. Fenwick and Gunderson each have a set of standard terms and docs. I believe Cooley has a set as well. I just reviewed as set from Lowenstein that looks quite good. If the preferred stock your investors want to purchase resembles these "standard preferred stock" sets, then you are probably working with an investor who is trying to be reasonable and fair.
As the AVC wise man JLM likes to say, "in life you don't get what you deserve, you get what you negotiate." When you are preparing to sell preferred stock to investors, make it a point to familiarize yourself with all the important terms, what they mean (both to you and your company), and what an "entrepreneur friendly" deal looks like. And then go get one of them for you and your company. It helps to have some leverage and leverage in financings means multiple investors at the table. So when you are dealing with sophisticated investors, make sure you have options and make sure you understand the key issues and don't settle for a bad deal.
Preferred stock doesn't have to be a bad deal for entrepreneurs. It can be a win/win for both sides. But you have to work at this part of your business just like you do at the other parts.