Preferred stock: What startup founders need to know

What is preferred stock?

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.

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 preferences. 

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

To better understand preferred stock and how it impacts your startup explore some common questions:

What are preferred shares in a startup?

Preferred shares in a startup are a type of equity granted to investors, usually venture capitalists, that come with special rights and privileges compared to common stock. These shares give their holders a priority claim on company assets in the event of liquidation and often include provisions like liquidation preferences and anti-dilution rights. Founders and employees typically hold common shares, while preferred shares are structured to mitigate investor risk.

Who is the preferred stock best for?

Preferred stock best suits investors seeking to mitigate risk in high-growth, high-risk startups. These shares provide priority payouts and protections, making them ideal for venture capitalists and institutional investors. Granting preferred stock is often necessary to attract funding, but founders must carefully consider and negotiate favorable terms.

Can a founder have preferred stock?

In most cases, founders do not hold preferred stock. Instead, preferred shares are primarily issued to investors like venture capitalists. These shares come with specific rights and privileges designed to protect the investors’ capital. Founders and employees typically own common stock, which lacks these additional protections.

What does it mean for preferred stock to be participating?

Participating in preferred stock gives investors the right to "double dip" during a liquidation event. First, they recover their initial investment, then share the remaining proceeds alongside common shareholders. This arrangement provides additional upside for investors but can significantly reduce the returns for common shareholders, including founders and employees.

Deal terms are increasingly standard

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.

What is a participating preferred term?

A participating preferred term refers to an agreement where holders of preferred shares receive their initial investment back and participate in the remaining proceeds based on their equity stake.

Gaviria says most venture capitalists will ask for and receive a liquidation preference called “1x, non-participating.” Since liquidation preferences are expressed as multiples of the initial investment, the 1x means they will receive a dollar back for every dollar invested, a full recouping of their money — if there’s enough to cover their initial investment. Common shareholders will divvy up what’s left.

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 costly — 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 guarantees that employees and founders won’t see much for their equity unless they manage to turn the ship around.

What happens to preferred stock in an acquisition?

Preferred stockholders typically get paid first in an acquisition according to their liquidation preference. For instance, if the company sells for less than its valuation, preferred stockholders might recover their initial investment or more. At the same time, common shareholders could receive little to nothing, depending on the remaining proceeds.

Investors might also ask for anti-dilution provisions. These clauses are 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 will 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 is preference and participation.    

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.  

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. 

What are examples of preference shares?

Examples of preference shares include:

• Non-participating preferred stock: Investors choose between recouping their investment or converting to common shares.
• Participating preferred stock: Investors recover their investments and participate in additional proceeds.
• Cumulative preferred stock: Accrued dividends must be paid before dividends are distributed to common shareholders.

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

1. exercising their liquidation preferences; or
2. converting their preferred stock to common stock and receiving a sum proportionate to their equity stake.

What is cumulative and non-participating preferred stock?

Cumulative preferred stock includes a provision where unpaid dividends accumulate and must be paid before any common stock dividends. On the other hand, non-participating preferred stock allows investors to choose between their liquidation preference or converting to common shares but not both.

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 a partner at venture capital firm Venrock.

“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 Tim Tuttle, Founder of MindMeld. 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.”

Conclusion

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

The second is to find a financial partner who can help you better understand the terms for preferred stock and help with introductions to law firms.

The third is to execute your startup’s plans: hit the key milestones and benchmarks and build a great product. If you do that, everything else can fall into 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.”