This is the standard for sophisticated angel investors and venture capital firms. Preferred stock is a different class of stock than the common stock owned by the founders and management. Preferred stock is superior to common stock because—it has preferences. The preferences fall into five potential categories:
- Liquidation preference (including a sale of the company) (this generally means holders of preferred stock get their money back prior to the holders of common stock getting anything);
- Dividend preference (holders of preferred stock would be paid a dividend before any dividend would be paid on shares of commons stock)
- Conversion rights (this includes the so called “anti-dilution” rights that protect investors from future financings at a lower price per share, called a “down round”)
- Redemption rights (an obligation of the company to repurchase shares of preferred stock) (it is rare to see these rights in early-stage transactions), and
- Voting rights (this can include the right to designate board members and class voting rights, called “protective provisions”, giving the investors certain veto powers over the company).
Through these categories of preferences the investors change the structure of the economics and control of the company. See related blog post: Less Risk, More Reward. A lack of a majority of the stock does not mean that the investors lack control of the company or will receive a smaller piece of the pie when the company is sold.
Our view is that money is still the precious commodity; investors deserve to get preferred stock and companies shouldn’t oppose selling investors preferred stock. Having said that, the terms of the preferred stock are fertile ground for negotiation, and smaller transactions warrant fewer of the “bells and whistles” available to investors under the preferred stock structure.
Image credit: CC by Michael