Venture investors require preferred stock instead of common shares
Imagine you raised $2M in your startup at a $20M valuation. Investors now own 10% of the business. You, the founder, hold 90%.
But after a year, all is not well. You want to pivot to a completely different business. The investors demand you stay the course. They have a seat on the board. Meetings become acrimonious. They even ask you to find a new CEO.
So you and your lawyer come up with a devious solution. You’ll sell the business to yourself for $1.
You sign the paperwork, duly deposit a dollar in the company account and voila! you now own 100% of the business. Bye-bye investors, it was nice knowing you.
Fair? Of course not. Legal? Probably.
Investors can try to argue the transaction was fraudulent, but that won’t be easy. A lawsuit will probably cost more than the investment, and for what? The best we can do is claw back the shell of a business without employees or customers. There’s really no choice but to write it off as a loss.
There are a million similar scenarios: the startup taking $1M in investment, then paying the founder a million dollar bonus; millions of shares sold to the founder’s family for a penny each; a successful business paying the founders huge salaries instead of distributing dividends to investors; the founder agreeing to an acquisition where he gets a lucrative new job but shareholders get nothing.
Public companies usually can’t get away with these kinds of shenanigans. Most of the stock of public companies is owned by independent shareholders, and there’s enough money at stake to fight any self-dealing by executives and majority shareholders in court.
But in the startup world, the founders usually hold the majority of the stock and control the board. Our incentives are not always aligned.
The solution: preferred shares.
What are Preferred Shares?
Preferred shares are essentially the same as regular common shares with a few critical differences.
First, and foremost, preferred shares get separate voting rights for key corporate changes such as acquisitions and issuing new shares. That means 50% of the preferred shareholders will need to approve any changes, essentially giving investors veto rights.
Another important difference is a liquidation preference. This guarantees investors get our money back prior to common shareholders getting a payout; i.e., if we invest $2 million at a $20M valuation (10% ownership), but the company is sold for only $5M, instead of getting only a $500K payout, preferred shareholders get our full $2M investment returned before the remaining $3M is distributed. (A separate article on liquidation preferences here.)
Preferred shares often include other rights important to minority investors, such as:
- board representation: guaranteed board seats and board observer roles for investors
- pro-rata rights: right to invest in future funding rounds
- information rights: requirement to provide regular financial updates to investors
- anti-dilution protection: protection against getting diluted in a down round
Other than these differences, preferred shares are treated the same as common shares. On acquisition or IPO, unless the liquidation preference is triggered, the preferred shares convert to common, meaning each share of preferred stock gets the same payout as a common share.
If dividends are ever paid (unlikely for a startup), each share of preferred stock receives the same dividend as a common share.
Other than having separate voting rights for certain key items, preferred and common shares each count as one share for voting.
Note that this is different from the similarly-named preferred shares issued by public companies. Those shares typically include required dividend payouts but have no voting rights, making them something of a cross between a corporate bond and public stock.
Why You Never Want to Sell Common Shares Anyway
The two-tiered stock structure also allows the startup to claim different valuations for each class of shares. This helps with tax treatment of employee stock options and advisor shares.
Imagine the startup is valued at $50M in a Series A. It hires an experienced head of sales and grants her options on 5% of the total shares. If those were preferred shares, they would be worth $2.5M, on which the employee would have to pay income taxes of over a million dollars, exactly the same as if she were handed a check for $2.5M (for which she’d at least have the cash to pay the taxes).
Not many prospective employees will be excited about paying $1M in taxes to join a startup and receive an options grant that most likely will never be worth anything. Similarly, it’ll be hard to sign up advisor and board members if they have to pay hundreds of thousands of dollars in taxes to receive their grants of 1% of the shares.
Fortunately, common and preferred shares are different categories of shares with different valuations. Preferred shares are preferred for a reason. With special rights, preferred shares are worth more than common shares. How much? Well…that’s open to opinion.
While investors are buying preferred shares that value the company at $50M, the company can maintain the fiction (best backed up with a third-party 409A valuation report) that using metrics based on big company profit ratios (startups never have any profits, and early-stage ones have little revenue, too), show the common shares are worth close to nothing.
Instead of paying a million dollars in tax for the huge options grant, the new executive might have pay a thousand dollars, and regular employees and advisors who receive modest options grants only have to send a check to the IRS for the equivalent of a nice lunch.
Perhaps the tax authorities will crack down on this practice someday, but for now this is standard procedure. As a founder, you don’t ever want to sell common shares at a price that will establish a venture valuation.
Common Shares are a Non-Starter for Venture Investors
As an early-stage startup investor, it’s not uncommon to hear pitches from founders offering investment in common shares.
Unfortunately for them, that’s a non-starter, and we hit the gong as soon as we hear the offer is for common shares.
They may have previously sold common shares to friends and family who aren’t aware of the difference. Oops. They may be working with an attorney who specializes in small businesses instead and doesn’t understand how venture startups work. Time to find a better attorney.
Because for venture investors, investments are always in preferred shares (or SAFEs or convertible notes that convert to preferred shares.) Common shares are for founders and employees only.
So as you prepare for your investment round, make sure you understand the difference between preferred and common shares, and be prepared to negotiate the special terms you’re willing to offer for the preferred shares.
The startup, SüprDüpr, sold millions of dollars in preferred shares to the crypto billionaire, Satoshi Nakamoto, and the VC firm, Sam Hill Ventures, while giving away advisor shares to the head of police, prominent politicians, and even newspaper publishers. What did they get in return? The answer will shock you. Find out in my Silicon Valley mystery novel, To Kill a Unicorn.
