Preferred Stock

When founders and investors both took the same shares in an early round, the arrangement left one side exposed. Founders put in time and labor while investors put in cash, and if the company doesn't work out the founders come away with experience and the investors come away with a loss. Contributing different things and receiving identical terms didn't add up.

The imbalance showed itself whenever a company sold for a middling amount. Suppose an investor put in $2,250,000 for a 20 percent stake and the company sells for $3,750,000. Split strictly by ownership, that investor collects $750,000. The founders take $3,000,000 and call it a successful exit while the investor recovers a third of the original money. Nobody failed, and yet the only party who lost was the one who supplied the cash.

Preferred stock is the share class that closes that gap by contract. It is still stock in the same company, but rights get attached: standing ahead of others when money is divided, and having a say in certain decisions. This is why most of the length of an investment agreement is about those terms rather than about the amount.

The rights attached to preferred stock vary by deal, but four of them appear in nearly every early round.

1. A liquidation preference. The right to recover the investment first when the company is sold or wound up. The standard is one times the amount invested, so an investor who put in $2,250,000 takes that back off the top and everyone else divides what's left. In the example above, a $3,750,000 sale sends $2,250,000 to the investor and $1,500,000 to founders and employees.
2. Conversion. The right to convert preferred shares into common shares. When a company sells for a large amount, taking a percentage beats taking the original money back, so the investor converts. If that same company sells for $22,500,000, a 20 percent stake is $4,500,000, and there is no reason to take $2,250,000 first instead.
3. Anti-dilution provisions. If the next round prices lower than this one — a down round — existing investors receive additional shares to compensate. Founders and employees absorb that adjustment a second time.
4. Consent rights. Selling the company, issuing new shares, and taking on large debt get written up as decisions requiring the consent of preferred holders. It functions as a veto and operates separately from voting power.

Priority on dividends is in the name as well, but it rarely matters at a startup, where profits go back into the business rather than out to shareholders.

The result is that agreeing on a valuation does not settle what anyone actually receives. A post-money valuation of $11,250,000 is not enough to calculate the founders' share; you also need to know whether the liquidation preference is one times or two, and whether the investor shares in what's left after taking the original money back.

When an institutional investor puts money into a startup, the shares they receive are almost always preferred. Individual angels writing small checks sometimes come in on common stock, but from a Series A onward exceptions are hard to find.

Each round adds a class. What the Series A investors received is called Series A preferred, what the Series B investors received is Series B preferred, and so on. Later rounds are often placed ahead of earlier ones, so in a sale the Series B recovers first, then the Series A, then common stock last. Reading that order off the cap table is what lets anyone calculate in advance who receives what at a given price.

Common stock belongs to founders and employees. Exercising a stock option also produces common stock, which puts the people working inside the company at the back of the distribution order. How much that matters depends entirely on the sale price. A large sale makes the ordering irrelevant and everyone takes their percentage; a middling one lets the parties in front take most of the proceeds.

Preferred shares in a listed company are a different instrument. They trade away voting rights in exchange for a slightly higher dividend, and they share nothing with startup preferred stock except the name.

"This round is 1x non-participating preferred."

The investor takes the original amount back first and does not also share in what remains.

"Once you apply all the preferred terms, the founders net far less than their ownership percentage suggests."

A warning against estimating sale proceeds from percentages.

"In a down round the anti-dilution clause fires and our ownership drops again."

Pricing lower next time costs more than the dilution itself.

When Pagedeck received its Series A term sheet, Grace spent longer on these terms than on the amount. They agreed on $2,250,000 at 1x non-participating, anti-dilution went in, and the list of consent rights was narrowed to selling the company and issuing new shares.

Afterward Grace built a table showing what each party receives at a $7,500,000 sale and at a $37,500,000 one. At $7,500,000 the investor takes $2,250,000 first and common stock divides the remaining $5,250,000. At $37,500,000 the investor converts and takes $7,500,000.

The most common mistake is multiplying an ownership percentage by a sale price to find your own share. Fifteen percent on the cap table and a $37,500,000 sale reads as $5,600,000. But the proceeds run through the priority order first, and percentages apply to whatever is left. If the invested amounts ahead of you total $15,000,000, that goes out first and your fifteen percent applies to the remaining $22,500,000, which is about $3,400,000. The smaller the sale, the wider that gap grows, and a price near the total invested leaves common stock with almost nothing.

The other belief is that preferred stock hands investors control of the company. The word preferred sounds like it extends to running the business. Voting power actually follows ownership, and a 20 percent investor is not a majority on the board or at a shareholder meeting. What does bind, regardless of percentage, are the items covered by consent rights. If selling the company or issuing new shares requires consent, there is a working veto on those items. That is why the negotiation is rarely about whether consent rights exist and almost always about how long the list is.