What is preferred stock and why is it issued to investors?

May 19, 2007

Preferred stock generally has rights senior to common stock. Startup companies typically issue common stock to founders (and options to purchase common stock to employees) and preferred stock to investors. One reason for issuing preferred stock to investors is to preserve the ability of a company to issue options to purchase common stock at an exercise price at a significant discount from the preferred stock price. Before accounting and tax rules became more stringent on the valuation of common stock, companies generally used to value their preferred stock as ten times more valuable than common stock until the 12 to 18 month period before an IPO. In other words, if Series A preferred stock was sold for $1.00/share, an option to purchase common stock would have an exercise price of $0.10.

If a company issued common stock to investors, then the exercise price of options to purchase common stock would generally need to be the same price as the price to investors. In this scenario, employees may not believe that they are receiving the benefit of “sweat equity.” However, there are some companies, such as broadcast.com, co-founded by Mark Cuban, that completed all of their pre-IPO financings by selling common stock.

Another reason that investors purchase preferred stock is to receive rights, preferences and privileges senior to common stock. The most important economic right of preferred stock is the liquidation preference, or the ability to recover the investment (and more) upon a liquidation or sale of the company. Other important rights of the preferred stock include voting provisions and anti-dilution protection. I will cover these and other rights in future posts.

Comments

  • Jeff

    Given the new more stringent accounting and tax considerations you reference, what are you generally seeing by way of rule of thumb for companies in terms of the difference (discount) in price for common stock and preferred stock, and does this vary based on whether or not the company decides to get a formal valuation of its common stock to take advantage of an IRS safe harbor?

    Also, what factors should the Board consider when valuing its common stock for purposes of setting a strike price for the option grants?

  • http://www.startupcompanylawyer.com Yokum

    In the past, WSGR has had summer associates collect data on companies that completed IPOs to determine their option pricing prior to the IPO and compensation charges subsequently incurred as a result of SEC review. I would guess that most early stage companies post-409A that are pre-revenue still end up with a common stock FMV at 10% to 20% of the last round of preferred stock. In later stage companies, I suspect that the percentage increases dramatically, with there being almost no difference when company valuations would result in happy M&A exits.

    Of course, percentage based math is not proper accounting. I think that any private company that has received venture financing probably should have a 409A valuation report done. It’s cheap insurance in the event of an IRS audit of a significant option grant in the future.

  • Tom Cerrato

    Setting up a closed c-corp. private investors will purchase common stock. Is their any way to protecting the c-corp from lawsuits that may loose assets. Can I form a Holding company, LLC to own the c-corp for protection. I was going to form a personal LLC to own my shares of company stock from the c-corp. Please help me in the structure to protect assets along this line…
    Thanks

  • http://www.startupcompanylawyer.com Yokum

    @Tom – Please read the disclaimers and discuss with your own advisors. I don't really see the incremental benefit of having an LLC own C-corp shares. That really won't prevent the C-corp from being sued. If a third party wants to sue various parties in the ownership chain, you really can't stop them and as long as the C-corp complies with corporate formalities, the stockholders won't be liable personally absent additional facts that would create liability.

  • http://www.startupcompanylawyer.com Yokum

    @Tom – Please read the disclaimers and discuss with your own advisors. I don't really see the incremental benefit of having an LLC own C-corp shares. That really won't prevent the C-corp from being sued. If a third party wants to sue various parties in the ownership chain, you really can't stop them and as long as the C-corp complies with corporate formalities, the stockholders won't be liable personally absent additional facts that would create liability.