Financing Options: Preferred Stock
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.
Moving the above into the mind of Angels, I’ve seen some bizarre looking disbursements to investors per announcements of companies being sold.If an Angel is one of the first investors, by all rights they should be rewarded. Is Preferred Stock the only way they can be protected? A HF guy has told me they’ve been burned too many times where they were the seed and then find out those who come in after the fact get sweeter deals.
Angels often don’t negotiate deals. They just take the security as presentedby the company. One idea would be to negotiate something like a MFN thatgives them at least as good a deal as those who come later
Thanks. I’m trying to cover bases.
Are you going to be posting stuff on G+ this week?Anxious to know your thoughts about what you see developing in that arena.
I’d love to auto import my posts to G+ as I do with FB and Twitter but Idon’t know how
Any chance US VCs will adopt a universal TS like they just did in the UK?
Would you mind explaining “universal TS”?
Link below to the press release, but it was reported on by TC and some other tech/vc blogs last month.http://seedsummit.org/legal…
“The fact that most entrepreneurs only go through this process a few times in their career adds to the challenge: after all, the investor usually knows what to expect.” I agree, and it begs the question, how much time should an entrepreneur spend away from their business to learn how VC term sheets? “While the documents provide many of the terms that are typically found within financing rounds, the eventual users of these documents ultimately decide which terms to include or not include. The origin of the initiative was inspired by the Series Seed docs of the USA.” I agree, because this helps promote an intelligent discussion as opposed to an exact one size fits all. I look forward to reviewing these standard term sheets. Thanks for sending, Robert
Taking OP money is like getting married.You meet a beautiful woman, fall madly in love and all it costs you is EVERY PENNY YOU MAKE FOR THE REST OF YOUR LIFE!Choose carefully. You may well die in her arms.
Unlikely and not sure they should. Not all investments are the same
In describing liquidation preference, you mention that if the sale is for more than the original valuation, then you get your % ownership back. In a 1X liquidation preference, don’t you get your 1x back *no matter what* and then the balance of the proceeds are distributed on a percentage basis?
You are describing a participating preferred which used to be very common inVC deals but not so much these days
Why is my world so different than yours? :)I have a meeting with a group of investors this morning and since Friday I have received four phone calls from the various parties that will be in the meeting this morning. None of the calls dealt with my proposal but all dealt with issues of “…what kind of deal are you proposing…”I have a hunch that the biggest issue I will face is getting everyone on the same page; I have no intention of making individual deals and I assumed that they would dictate terms; but its apparent that everyone thinks someone else might get something different than they will.Not real sure how that happens considering we will all be sitting around the same table in a few hours…but at least I have read every single MBA on Monday…and quite a few other blogs this weekend.
Put forward a proposal and tell them this or something similar is whateveryone is going to get
One of the things I respect the VC world for is putting a logic to why they invest in what they do. Basically, you are focused on developing companies and then selling them….profitably.So, everyone at the table has the same motivation because they have the same end goal in mind. From what I know I am faced with three different end goals….two want an income stream, one invests to eventually own everything outright, and the final one just wants in because everyone else is interested.So I am putting a proposal together based upon MBA Monday that creates an income stream (dividends) but establishes a milestone where the one company buys out, at a set price, the whole company.That should satisfy at least 3 out of 4.
Oh, and before I forget, and assuming I am successful, I have a blog post where I am asking for help…So, if any of you are interested in educating and or mentoring I would appreciate your assistance!
…the entrepreneurs were in negotiations on preferred stock options with an investor with valuable connections and reputation that would benefit the company. When it came to signing the papers, the investors said it would be “participating preferred” where the investor gets paid back all the money he invests plus equity. The entrepreneur said, “that’s not what we had agreed to”. Investor: “but don’t you think that’s fair?” Entrepreneur: “I don’t give a shit what you think is fair, that’s not what we agreed to.” –Barry Nalebuff, Honest Tea founder and now a professor at Yale in “Why you shouldn’t to be an entrepreneur?”. http://discover.odai.yale.e…Preferred stock may be fair, but participating preferred seems unfair.
I love it
Fred,I have a question on timing.Since Series A and later rounds usually involve the VC handing the entrepreneur a term sheet that has to be accepted or rejected within 24-48 hours, when does the negotiation and standardization of the terms happen in the process, especially if there are multiple firms each going through their own due diligence timeline?
I have a followup;How do you negotiate the gospel of Fred and stock, if the situation above is common?
All temporal deadlines in life — except for death which is not technically “in life” — are set by mortals and are negotiable.When someone in business says you HAVE to do something, look him in the eye and say: “The ONLY thing I HAVE to do is to save my immortal soul.”I promise you this takes the baloney out of the situation.Hint: the world is not going to end on 2 August if we don’t get a debt deal. Bullshit temporal deadline made by mortals. If you are building aircraft carriers on the side, your August payment may be a bit late.Don’t let folks push you around when it comes to artificial deadlines.
Beautifully stated. Your post is suitable for framing.
I don’t believe in exploding term sheets. Our term sheets have no expirationdate on them
OK, so Preferred is mostly about getting the investor’s money back if the deal ultimately isn’t a winner.It’s interesting because the common thinking on venture math takes the proverbial 10-company portfolio, assumes that 1 (maybe 2) deals return the whole fund and then some, and that 6-7 of the deals become *total* write-offs. Maybe the implied point in this post is that they don’t need to be?I wonder just how much this practice moves a fund’s IRR needle.
I think preferred is mostly about: I say my highly illiquid, controlled by me, company stock is worth $X. We agree and you put up $Y of cold hard cash. What’s $X worth?? We don’t know until its sold. We know what $Y is worth, so if its sold why would investor not get at least $Y back? It is the one thing that is not a variable.Its one area where I would agree you do have a responsiblity to investors. It always sucks to look at worst case but that is what lawyers do and worst case without preferred you could take the money, lets say $5M for 30%, turn around and sell the company for cash on hand, and give back the investor $1.5M
I dig that rationale behind preferred stock and it’s how I explained the concept to my wife.And in situations where it’s hard to raise, I can understand the more severe participating preferred multipliers.
I must say for that very reason I do not like participating preferred or multipliers. I might consent to a accrued but unpaid dividend on a cost of money basis, right now its like 2% but I could live with 6% non compounding, max and even there things are going to diverge but it gives you the basis for a divorce if things don’t work out at the end of the VC’s fund life.The reason is you’ve now gone away from the concept. You’re not guaranteeing a return. That is a debt instrument. You are saying, if my share is not worth what I said I will make you whole.Not you get a guaranteed return and all the upside.Charlie Crystle can give you all of the bad use cases on this one.BTW: Charlie I ate at the Deer Park for Dinner today.
good points. agreed re debt instrument. I mention that in my other comment on this page (re being a service provider and getting paid in equity).
Its not just about the preference. Its about the rights privileges andpreferences
I really like your paragraph about why to specialize in the relatively benign.Shows a long term view, and is indeed true.
I’m looking for examples of where preferred stock are also made available to service providers.That’s what my company is. We’re starting to occasionally take some equity as a portion of our fee (usually at the client’s urging). Since we’re an operating company (and a startup ourselves), the chief goal is to simply get paid at some point. Debt is obviously a clearer way to achieve that, but Preferred starts to sound good too.
As both a service provider and a startup entrepreneur (different hats), I think this is an interesting sub-topic.I’ve never really heard of this happening but, sure, it does make sense that if you are a service provider taking a %age as remittance for services rendered that you would want a liquidation preference in order to ensure you at the very least get your costs back. If you held common and the company exited below valuation you would otherwise be out of pocket.However that also means you are essentially footing a lot less risk as the below-value exit risk has just been taken off the table and so I would assume you could only reasonably request a %age of equaling the value of your invoice, rather than doing a service-for-options deal on common where you might be able to negotiate a greater share.If you are providing an on-going service (eg legal) then it also would make sense to have this vested over the period of the service provision, which is not going to happen with preferred.Something like this could presumably only occur during a funding round as the cap table would be being altered. I’m also not sure why it wouldn’t be smarter for the entrepreneur to raise the capital needed for your service directly from an investor who will then provide additional value to the company beyond just the financial investment?
As a service provider who often gets asked to take a percentage, this concise, straightforward explanation of the limitations of this arrangement will no doubt help me decline more elegantly. Thank you.
When we’re asked for this, it’s generally because the company has very good reasons to delay the next round, or it’s taking extra time, etc.And also, I can answer my own question partially here: many top angels say that they look at their investment assuming the money is gone, and it’s a bonus if they see it returned at all. So assuming you’re a service provider offering a very hot service (we are) in a very hot market (it is), you really should only take such a deal from a company that you really believe in and/or is very strategic.
Any sense of the percentage of deals which are preferred vs common? What about the timing of the deal i.e. are preferred shares more likely in the seed round, series a, all funding rounds? It makes sense to give preferential treatment to early round investors but less so for the last money in.
The vast majority are preferred
How does the existence of two types of shares (say, preferred and common) effect the pricing of employee options?
Two types of shares can actually be good for employees – the existence of preferred means common options/shares get valued lower, which makes early exercise and 83b elections less painful. If there is only one class of shares it eliminates flexibility in pricing the common, so exercise cost can get expensive.As for the exact formula, hopefully Fred can speak to that.
Thanks. Yeah, I’d love to understand how this works better.
Options are for common and struck at the value of the common not thepreferred
Can founders/entrepreneurs get preferred stock instead of common stock? Since the founders are the ones issuing the stock, wouldn’t they always own preferred? Or is it primarily a situation where the founders don’t know better? Or are there rules that say they can’t own preferred stock?
There is no technical reason founders can’t issue themselves the same preferred stock sold to investors, but it is extremely rare unless the founders are buying the preferred stock for cash at the same price as the investors. The tax issues can be very tricky too because the shares must be paid for with cash or assets equal to the value of the preferred stock (or the excess value will be treated as taxable income). Having worked on the formation and financing of hundreds of startups, I only ever once issued investor-class preferred stock to the founders, and, in that case, investors in a later round of financing conditioned their investment on the founders converting their preferred stock to common stock.I think Philip Sugar’s comment below perfectly captures the rationale behind liquidation preference: in contrast to the value of the generally intangible assets contributed by the founders or developed by the company, there is no uncertainty about the value of a cash investment, so stockholders investing cash should therefore be paid back first.There are a couple flavors of “founders preferred” but they are different from the preferred stock issued to investors. Steve Newcomb has a good recent post about “founders preferred” http://blognewcomb.squaresp…
That is an interesting writeup, which brings up another interesting case which is a follow on round or more importantly a buyout offer.If you have a buyout offer for $Cash which values the company at more than the preference level, then in fact the entrepreneurs value is not uncertain.To my thinking if the preferred’s do not want to take the offer and instead swing for the fences with a “thunder lizard” then you need a big rethink/adjustment to the common’s in order not take the offer.
In some ways, this is a simple voting issue to be determined by the voting rights of the fully diluted common stock.Voting rights are a core consideration in configuring common stock v preferred stock.I do bend either way but I would always address it.It is not uncommon for a more mature company to take a proxy from the “new investor” for some period of time. Typically this proxy is held by the Board less the new investors.I have done it exactly this way.
Yes, voting and drag along rights are important in this issue but only when you go nuclear, and get the scriveners working.However, I am more talking about where the commons might agree with the preferred, but should not continue to shoulder all of the downside risk.They have proved the value of their asset, and therefore the preferred should give up their rights. That is not a tax issue, but is something preferred’s are loath to do.This is happening somewhat with the all of the secondaries that are now happening, but I wonder how long this window will last.
They’d have tax issues with preferred. They’d pay tax on the preferencesince they aren’t paying cash for it
we’re not lawyers (ok – Jason is) and this isn’t legal advice so you should not rely on it for anything, yada yada standard disclaimers follow. In other words, use at your own risk.Online PMP Training
I understand most Angels and VCs expect preferred stock. However, should an entrepreneur offer this upfront straight away in their business plan and other presentation docs? Or is it better to initially offer common stocks with the expectation that investors will negotiate for preferred stocks?
FYI: Participating preferreds are not legally enforceable in India: http://www.vccircle.com/col… (post by Mohanjit Jolly, a partner with DFJ in India)
The information is very valuable .Thanks for sharing it.