Startup Preferred Stock: What Founders Need to Know | Silicon Valley Bank (2024)

They cut investor risk but you shouldn’t give up more than necessary

In the world of startups, not all shares are created equal. The VCs who finance unproven companies will insist on contractual agreements that mitigate the risks they take with their money. Those contracts are expressed in the terms of underlying preferred stock. As you negotiate those terms, it’s important to understand what they mean — and to make sure you don’t give away the store before your startup gets going.

--Lewis

The story is all too common in Silicon Valley. A high-profile startup sells for tens of millions or better. It’s not the home run many were hoping for, but it appears to be a solid single or double. And yet, after the dust settles, employees, and sometimes founders, find that their equity stakes in the company are essentially worthless. Investors, on the other hand, fare better, sometimes recouping their money or even pocketing a positive return.

“That’s how it works,” says Tim Tuttle, founder and former CEO of MindMeld, a maker of conversational apps backed by artificial intelligence that was acquired by Cisco in 2017. “The people that give you money get paid back first.” The same dynamic, where investors take precedence over employees and founders, comes into play when a company is shuttered.

Welcome to the world of preferred stock. It is an essential part of venture deals in tech and beyond. And before issuing it, entrepreneurs must understand what it means, how it is structured and how it behaves in different scenarios.

VCs demand liquidation preferences to mitigate their risk

Founders don't get preferred stock. But it's nearly impossible to raise venture capital without issuing preferred stock, or preferred shares. In most cases, VCs today won’t hand over a dime in exchange for common shares, the form of equity extended to founders and employees.

Preferred stock, unlike common stock, is exactly what the name implies. Its owners receive preferential treatment over other investors in specific situations. What exactly that means is negotiable, and it will end up in the fine print of your term sheet. It can involve a wide range of special rights. The most common and important is the liquidation preference.

If your company is a runaway hit, you’ll likely never have to worry about liquidation preferences. But if your startup goes out of business or ends up selling for less than what it was once valued, liquidation preferences will come into play. The liquidation preferences mitigate the risk investors face by ensuring they get paid first. The fine print will determine how much, if any, remains for you and your employees.

Fortunately, deal terms are increasingly standard

It’s not as bad as it sounds. That’s because deal terms have become increasingly standardized, says Ivan Gaviria, a partner at Gunderson Dettmer, a Silicon Valley law firm that has worked with startups for decades. And today’s standards tend to favor founders.

“The leverage is with the entrepreneur,” Gaviria says. “There’s a ton of capital available and a lot of competition for deals.”

"The people that give you money get paid back first.”

The term “non participating” means that the investor has a choice. He or she can receive their original investment back or convert their preferred stock into common stock and share in the proceeds according to their equity ownership, whichever amount is greater.

While terms are becoming standardized, sometimes entrepreneurs get into trouble because they are fixated on maximizing their company’s valuation in a given round. “I have seen companies raise money and negotiate for higher valuations and, in trade, they give up more favorable liquidation preferences,” says David Van Horne, a partner at the law firm of Goodwin Procter. “More often than not, that ends up being a bad trade.”

Later financing rounds can get trickier

In latter financing rounds, matters can become more complex and dangerous — especially if your company has struggled to hit milestones. In these situations, investors might ask for 2x or 3x liquidation preferences, meaning they would receive twice or three times their original investment before common shareholders are paid. That all but guarantees that employees and founders won’t ever see much for their equity, unless they manage to turn the ship around.

Investors might also ask for anti-dilution provisions. These are clauses designed to protect an investor’s ownership percentage from being diluted in future funding rounds where the company issues new stock for a lower price. If an investor has negotiated an anti-dilution clause, their stake in the company is maintained through formulas that turn each preferred share into more than one common share. Exactly how much more depends on the situation and the method specified in the anti-dilution agreement.

Beware of ‘double dipping’

If a company lacks leverage, investors sensing big risks might even try to negotiate for “participating preferred shares,” also known as the “double dip.” Says Gaviria: “Preferred participating is the thing you want to be wary of.”

During a liquidation event, an investor with participating preferred rights is first in line to recoup their initial investment. If any proceeds remain after that, the participating preferred investor would then pocket an additional share proportional to their percentage ownership stake in the company on a pro rata basis with common shareholders. (Pro rata is a Latin term that means whatever is allocated will be distributed equally.) Hence, the double dip — preference and participation.

“If a company sells for $100 million,” says Gaviria, “an investor with participating preferred shares might take their original $20 million investment off the top and then take 20% (their percentage share of the company) of the remaining $80 million such that common gets 80 cents on the dollar on the amount remaining after the preference.” In later rounds, common shareholders could end up with as little as 30 or 40 cents on the dollar, Gaviria adds.

An example of preferred stock with and without liquidation

Say a company raises $500,000 in its seed round at a post-money valuation of $2.5 million, giving investors a 20% stake. The chart below shows how much money investors receive if the company is sold for between $2 million and $6 million.

With non-participating preferred stock, investors get to choose the greater of

1. a) exercising their liquidation preferences; or

2. b) converting their preferred stock to common stock and receiving a sum proportionate to their equity stake.

In the worst case scenario for founders and employees ($2M exit with 2.0x liquidation), common stockholders with 80% ownership will receive $1 million — the same amount as preferred shareholders with 20% stake.

Giving up too much can hurt later

It’s important to remember the terms of preferred shares are negotiated between founders and investors. Founders who agree to give up 3x preferred participating rights are typically desperate for money. In a bull market, such terms are very rare, said David Pakman, who founded one of the first cloud-music companies and is now a partner at venture capital firm Venrock.

“The leverage is with the entrepreneur.”

“If investor X asks for a bunch of things that are completely out of market that no other investors are asking for,” Pakman said, “then he or she is unlikely to get them unless the entrepreneur is having a super hard time raising funding.”

Cash-strapped founders must make these decisions very carefully, as they could have dire consequences later, says MindMeld’s Tuttle. Consider the following scenario, Tuttle says: You do a financing in desperation where you agree to a high liquidation preference and shortly after, you get a modest acquisition offer. While the deal would have been life-changing for founders and employees, due to the high liquidation preference, they don’t see any upside. “In that moment it’s very frustrating for founders,” Tuttle says. “But the reason they’re there is because they weren’t able to convince investors to give them the money they needed to get there without introducing these aggressive terms to offset the risk.”

Takeaway: It’s a leverage game

There are two important things you can do as a founder to mitigate the possible downside of preferred stock. The first is to hire a good advisor — someone with experience who knows the landscape and the players.

The second is to execute on your startup’s plans, hit the key milestones and benchmarks and build a great product. If you do that, everything else falls in place. Gaviria says he often finds entrepreneurs too focused on deal terms and valuations. His advice is to concentrate on building a great business. “I tell them, ‘Hey, let’s focus on getting the investors to fall in love with your company, your team, you.’” he says. Like with any negotiation, he adds, “most of this stuff is a leverage game.”