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.