Why Do Companies Issue Preferred Stock?

Preferred Stock is stock which is “preferred” over common stock in any number of different ways.  For example:

  • Preferred stock may have a liquidation preference, which is a right to be paid first a certain fixed or formulaic amount of money before the common stock or other junior series of preferred stock are entitled to receive any portion of the proceeds from a liquidation or sale or merger of the company into another company;
  • Preferred stock may have purchase price anti-dilution protection, which means that if the company issues additional stock in the future at a price per share lower than the price per share at which the preferred stock was sold, the preferred stock’s purchase price will in effect be reduced as a result of the subsequent stock sale at the lower price;
  • Preferred stock may have special voting rights (including protective provisions, such as the right to block a subsequent financing or sale transaction);
  • Preferred stock may be entitled to dividends before any dividends may be paid on the common stock or other junior series of preferred stock; or
  • Preferred stock may have redemption rights, meaning the holders will have the right to have their preferred shares redeemed after a certain period of time.

Preferred stock may have any one or more of these characteristics.  In addition, preferred stock holders may desire contractual rights in addition to the rights specified above–such as:

  • A voting agreement with the other stockholders, ensuring the preferred stockholders representation on the company’s board of directors;
  • The right to attend board of director meetings as an observer;
  • Registration rights;
  • The right to receive financial statements or other information on a regular basis;
  • The right to meet with management and inspect the company’s properties;
  • Preemptive rights on future stock financings;
  • Rights of first refusal on sales of founder stock;
  • Co-sale rights on founder stock;
  • Drag along rights; and
  • Other rights.

Companies issue prefer stock for any number of reasons, but most typically, because their investors demand it.  For an example of a Series A Convertible Preferred Term Sheet, see the National Venture Capital Association’s model legal forms page.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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