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.
Posted in Financings
Tagged Angel Financing, Angel Funding, Angel Round, Common Stock, entrepreneur, Preferred Stock, seattle, seattle startup lawyer, Seed Financing, Seed Round, startup lawyer
Venture capitalists and sophisticated angels typically insist on receiving preferred stock for their investments in emerging companies. As a result, companies pursuing such investments often ask “what rights come with preferred stock?” First, it is important to recognize that all preferred stock is not the same. Second, preferred stock terms requested by a venture firm may be a bit more onerous than those sought by angel investors.
Typical preferred stock rights and preferences can include:
- Liquidation preference
- Dividend preference
- The right to convert to common stock
- Anti-dilution protection (meaning, purchase price anti-dilution protection)
- Blocking rights on significant actions of the company (e.g., company sale, equity financings, increase in option pool, etc.). Sometimes these rights can extend to governance matters such as the right to approve the appointment of senior executives, to incur significant indebtedness, etc.
- Rights of first refusal with respect to transfers of stock by the founders and sometimes other shareholders
- A co-sale right to sell stock on a pro rata basis if the founders sell stock
- Right to appoint a member(s) to the company’s board of directors
- Rights to participate on a pro rata basis in future equity offerings of the company
- Rights to demand that the company engage in a public offering and/or register the investor’s shares for sale into the public market
- Information and inspection rights
The extent to which a company will be required to grant such rights will depend on the context of the financing, including the type of investors (e.g., venture capitalists or angels), the relative leverage of the parties and the rights granted by the company in prior financing rounds. With respect to the last point, a company should recognize that the rights it granted in its last financing round will serve as the starting point for its investors in the current round. These investors will typically get at least those rights or better.
Founders often create intellectual property prior to forming their company. A common but easy to avoid mistake in early stage companies is the failure to properly assign such IP to the company. It is important that at the time of company formation, all IP critical to the company’s value proposition be properly assigned to the company. This is accomplished by having the founders and other individuals who may have contributed to its creation execute IP assignment documents in favor of the company.
Failure to assign critical IP to the company can give the individual(s) holding rights in such unassigned IP significant leverage over the company when the company goes to seek venture capital or realize a liquidity event. Such an individual could also use such unassigned IP for his or her own competitive purposes, thereby eliminating what the founders had likely intended as the company’s exclusive rights to such IP. For these reasons, potential investors and acquirers will typically confirm in their due diligence that the company has rights, whether by ownership or license, to all IP critical to the company’s business. As a result, the failure to properly assign critical IP at the time of formation can materially impair the company’s value and the founders’ ability to recognize such value in an equity financing or through a liquidity event such as a company sale or public offering.
By Sarah E. Tune and Mohsen Manesh
When a company begins experiencing financial distress that threatens its continued existence, its directors and officers must be vigilant about exercising their fiduciary duties. The company’s equity holders as well as outsiders will view decisions made during this time with particular scrutiny. Additionally, there are areas of law that attach personal liability to directors and officers; and, while risk of personal liability always exists, even in healthy firms, the potential for liability is heightened when a company is in financial distress.
Compounding the risks of personal liability, a financially distressed company may lack the resources necessary to indemnify its directors and officers, notwithstanding the indemnification agreements it may have with such individuals, and may even allow its director and officer insurance policies to lapse, because it is simply unable to pay the premiums. Continue reading…
Q: What is participating preferred stock? What distinguishes it from non-participating preferred stock? Who prefers participating preferred stock, and who prefers non-participating preferred stock?
A: Participating preferred stock is preferred stock that entitles the holder to a specified preferential payment upon liquidation and a share in any remaining liquidation proceeds on an as-converted to common stock basis. For example, if a company that issued $1 million dollars in participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the participating preferred stock would be entitled to receive a $1 million liquidation preference (or more, if specifically agreed upon), plus 10% of the remaining proceeds available for distribution, for a total of $1.9 million. If the same company sold instead for $15 million, the participating preferred stockholders would be entitled to $1 million plus 10% of $14 million dollars for a total of $2.4 million in total distributions.
In contrast, non-participating preferred stock is preferred stock that only entitles the holder to the preferential liquidation payment and not a share in any remaining liquidation proceeds. Using the example above, if a company that issued $1 million dollars in non-participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the non-participating preferred stock would be entitled only to their $1 million liquidation preference, and the remaining $9 million in proceeds would be distributed to the other stockholders. Note however that if the company was sold instead for $15 million, the holders of non-participating preferred stock would typically elect to convert their holdings to common stock in order to receive 10% of $15 million, or $1.5 million, an amount greater than their liquidation preference.
Thus, from an investor’s perspective, participating preferred stock is preferable to non-participating preferred stock as it both allows for a preferred payment upon liquidation and participation in the upside if the Company is sold at a premium.
This article is not intended to be legal advice. You should always consult with an attorney before making an investment.