Founders contemplating an angel financing often ask whether their company should issue common or preferred stock to angel investors. A fundamental difference between the two is that preferred stock has a liquidation preference, which upon a liquidation or sale of the company entitles the holder to a payment prior to distributions to the common stockholders. Thus, from the founders’ perspective it is typically desirable to issue common stock so the founders are on parity with the investors with respect to liquidating distributions. Issuing common stock also results in a simpler capital structure as the company will have only one class of stock outstanding (and thus will not be disqualified from making an S corporation election for having more than 1 class of stock outstanding).
Whether to issue common or preferred stock depends on a number of factors, such as:
- does the entity want to make or maintain S election status;
- the type of investor (friends & family investors will typically accept common stock, while organized angel groups will typically expect preferred stock). (Note, however, that all preferred stock is not the same – a topic for a future post.)
The relative leverage of the parties also plays a role. If the founders have multiple term sheets from different investors or they can persuade investors that their company has a significant upside potential, they may be able to issue common stock. I recently observed a company decide to go with a term sheet with a lower pre-money valuation than other offers because the investors were willing to accept common stock. The founders felt that the benefit of not granting preferred stock rights, which included the right to block a sale of the company, was worth the slight compromise.
In conclusion, it is typically better for the founders if the company issues common stock to angel investors. Of course, issuing preferred stock in an angel financing is typically better than no angel financing.