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- In startup investing, investors typically negotiate for preferred shares, while founders and employees usually receive common shares.
- Preferred shares confer certain advantages to investors that help them mitigate their risk, such as protective provisions and liquidation preferences.
- Not all preferred shares are created equal. Different preferred share classes may have different rights.
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Startups generally issue two types of shares—common and preferred. In venture investing—especially at the earliest stages—investors typically negotiate for preferred shares. Meanwhile, founders and the company’s employees usually receive common shares.
Why is this the case? What are the benefits of preferred shares that make them the desired share class for venture investors?
In this guide, we’ll compare preferred shares vs. common shares in the context of venture investing and share examples demonstrating exactly why venture investors usually ask for preferred shares.
Understanding Preferred Shares vs. Common Shares
The role of preferred shares in the private markets (like venture investing) is quite different compared to their role in the public markets.
In venture investing, investors typically receive preferred shares of the companies they back, while founders and employees receive common shares. The investor’s preferred shares may convert into common shares at some future liquidity event, like an IPO or acquisition (the specifics of what happens upon a liquidity event will be spelled out in the term sheet and, after the round closes, in the startup’s corporate documents).
Both types of shares—preferred and common—grant the holder partial ownership rights of the company. However, preferred shares also confer certain key benefits for investors. For example, preferred shareholders might get paid ahead of common shareholders if the company fails or they might get protected from getting overly diluted as a result of future fundraising rounds.
Benefits of Preferred Shares
Startup investors often come in as minority shareholders, meaning their shareholding percentage alone will not give them control over the direction of the company. With preferred shares, however, they can gain certain privileges over common shareholders that allow them to both exert a level of control over the company and limit their downside risk.
The key benefits of preferred shares include:
- Liquidation preferences. If the company undergoes a liquidation event—be it a selloff, acquisition, or IPO—preferred shareholders have a higher liquidation preference than holders of common stock. This means they will be paid before common shareholders (but after debtholders). Liquidation preferences can be participating or non-participating, which we’ll discuss in detail below. This distinction will affect how preferred shareholders are repaid upon a liquidity event.
- Anti-dilution protection. Anti-dilution protection provisions protect investors against dilution by future investors. Such dilution can be in the form of a “down” round—where the valuation of the company has fallen. Dilution can also occur if the investor’s shareholding percentage is reduced in a subsequent fundraise (even if the valuation of the company continues to increase). In the former instance, mechanisms that adjust the price at which preferred shares convert into common shares can be put in place. To prevent the latter source of dilution, pro-rata rights—which give the investor the right to invest in future rounds to maintain their shareholding percentage—are common.
- Other protective provisions. Investors often negotiate for protective provisions that allow them, as preferred shareholders, to veto certain corporate actions that could impact their investment—such as selling the company.
- General voting rights and board representation. In public companies, preferred shareholders generally do not have voting rights. But in venture investing, preferred shareholders can negotiate for similar voting rights as common shareholders—as well as the ability to elect members of the board of directors. A sample voting rights provision could look like this:
“The Series A Preferred shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except(i) [so long as [insert fixed number, or %, or "any"] shares of Series A Preferred are outstanding,] the Series A Preferred as a class shall be entitled to elect [_______] [(_)] members of the Board (the "Series A Directors"), and(ii) as required by law.”
Benefits of Preferred Shares Example
One of the most important benefits of preferred shares is their liquidation preferences. These don’t just mean that preferred shareholders get paid out ahead of common shareholders in the event of a bankruptcy or liquidation. The preferred shares’ liquidation preference can also dictate the amount that preferred shareholders would receive upon liquidation.
There are two types of liquidation preferences—participating and non-participating. In a participating liquidation preference, preferred shareholders would receive both their liquidation preference (a contractually specified return multiple) and a pro-rata share of any remaining funds along with the common stockholders. In a non-participating liquidation preference, they can choose either one, but not both.
Here’s an example that shows how both types of liquidation preferences can help protect an investor’s downside.
Assume an investor invested $1M in a company at a $4M pre-money valuation. This would equate to a $5M post-money valuation, with the investor now owning 20% of the company (the founders and employees own the remaining 80%). Let’s suppose the investor received preferred shares in return, with a 2x liquidation preference.
Unfortunately, some time later, the company fails and has to be sold for only $3M.
If those preferred shares had participating liquidation preferences, the investor’s total proceeds from the sale would be $2.2M, which breaks down as follows:
Total proceeds = Liquidation preference + Percentage share of remaining proceeds
= (2 x $1M) + [Ownership percentage x (Total Sale Price – Liquidation preference)]
= $2M + [20% x ($3M - $2M)]
= $2M + $0.2M
= $2.2M
In the case of a non-participating liquidation preference, the investor can either choose to take their liquidation preference of $2M, or receive $0.6M (being 20% of the total sale price of $3M). In this instance, they would take their $2M liquidation preference.
This means the common shareholders would be left with either $0.8M or $1M of the $3M—even though they own 80% of the company. Meanwhile, the preferred shareholder got at least double their money back. This is how liquidation preferences can protect an investor’s downside risk.
Benefits of Common Shares
As previously mentioned, founders and employees typically hold common shares.
For employees, common shares have a few benefits:
- Skin in the game. By receiving equity in the company they’re helping build, employees can share in the financial returns if the company is successful. For this reason, companies often use common shares as a recruiting and retention tool.
- Cheaper than preferred shares. Because common stock doesn’t come with the rights and privileges afforded to preferred shareholders, the cost of purchasing the stock is generally lower than the price investors will pay for their preferred shares.
As for founders, there are a couple reasons they take common shares instead of preferred shares:
- They already have control over the company. Founders will already hold a majority stake in the company and have appointed much of the board of directors (at least during the early stages). They don’t need preferred shares to exert control over the company.
- Issuing preferred shares to themselves could make the cap table unnecessarily complicated and deter investors. Because each class of preferred shares can have different rights—such as liquidation preferences—they can lead to a messy cap table. This could deter future investors.
Not all Preferred Shares are Created Equal
Finally, remember that not all preferred shares are created equal. Investors in different financing rounds may receive preferred shares with different privileges. Investors in later rounds may also ask for specific privileges accorded to earlier investors to be renegotiated—such as anti-dilution protection.
