What is Series FF stock?

December 22, 2007

[Note:  this post will likely get updated in the near future.] 

I’ve been asked by a few people about the Series FF stock that has been advocated by the Founders Fund. Matt Marshall of Venture Beat reported on this invention in December 2006. See here for an Inc.com report in March 2007. Michael Martin blogs about economic incentives associated with the Series FF and founders receiving some liquidity in connection with a venture financing. Series FF stock has also recently received some attention due to the announcement of the Founders Fund raising a $220 million fund in December 2007. See additional coverage from Venture Beat, TechCrunch and the Mercury News.

I’ve reviewed the Certificate of Incorporation of a couple of WSGR clients that have implemented Series FF stock. (Please note that anyone can obtain the Certificate of Incorporation of a Delaware company from the Secretary of State of Delaware.)

The Series FF is an interesting mechanism for founders to obtain liquidity in connection with a venture financing. Below are the main features of the Series FF stock:

  • The Series FF is basically identical to common stock except that it is convertible at the option of the holder into the same series of preferred stock issued in a subsequent round of equity financing if the buyer of the Series FF purchases it in connection with the equity financing.
  • The conversion into preferred stock can only occur if the buyer of the Series FF pays the same price per share as the shares of preferred stock sold in the equity financing.
  • The conversion into preferred stock can only occur if the board approves the conversion.
  • The Series FF is convertible into common stock at any time at the option of the holder.
  • The Series FF automatically converts into common stock upon a qualified IPO or upon the consent of holders of a majority of Series FF.

By the way, the Series FF preferred stock doesn’t need to be called Series FF.  It can be called Series A, Series Q, Series Z, Series X, etc.  The Founders Fund has managed to do some branding by referring to it as Series FF.

Below are some things to keep in mind about Series FF stock:

  • Pricing of the stock is complicated. Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). If the Series FF is not issued at initial incorporation, then issuing the Series FF stock at a later point in time will require the founders to pay more than a nominal amount to purchase the shares. As I will describe in a later post, founders stock is typically issued at a very nominal price per share, such as $0.001, so that the company may initially issue 10,000,000 shares for $1000.
  • If the Series FF is issued immediately prior to the Series A financing, then the price per share of the Series FF probably should be at least the same as the Series A. In some respects, the Series FF may be more valuable than the Series A in the future if it can convert into a later round of preferred stock with a liquidation preference greater than the Series A. On the other hand, there is significant risk that the holder never receives liquidity because the board might not allow a conversion to occur (or investors may not be willing to purchase).
  • Legal fees incurred in issuing Series FF may be higher. This is because the Series FF receives some amount of custom drafting and tweaking compared to a typical incorporation. In addition, many attorneys are not familiar with the concept and there are costs incurred in “reinventing the wheel” and getting everyone comfortable. The additional costs involved in setting up the Series FF may be wasted if the future board does not allow the founders to obtain liquidity.
  • It is unclear whether venture funds are willing to allow founders to sell a portion of their stock in connection with a venture financing. Implementing the Series FF before an equity financing sends a message to potential investors that the founders want liquidity in connection with an equity financing. This may not be a good thing to mention when looking for early rounds of financing. However, venture funds may be willing to allow founders to sell in the following situations:
    • The venture fund has to agree to it because there are multiple terms sheets in a competitive deal.
    • The company is doing well (i.e. valuations above $100M and nearing an IPO) and the founders would rather sell the company that wait longer for liquidity.
  • Investors prefer to purchase newly issued shares supported by a legal opinion, representations and warranties and various contractual rights. I’m not sure what benefit the company receives by facilitating the sale by the founders as the company does not receive the funds from the investors.
  • Other mechanisms exist to allow founders to receive liquidity in connection with a venture financing. Companies can repurchase founders common stock for cash, subject to various limitations. The main issue that the Series FF solves is the price difference between preferred stock and common stock. If common stock is repurchased by the company at the same price as preferred stock is being sold to investors, then the fair market value of the common stock for option pricing purposes probably should be the preferred stock price. However, in a company nearing an IPO, the common stock FMV will likely be very close to the preferred stock price anyway. Therefore the Series FF stock probably only incrementally solves for a situation where founders want liquidity and want to preserve a significant price difference between the common stock and preferred stock in an early stage venture financing. (I’ll write a future post about option pricing and 409A in the near future.)
  • Because the Series FF will likely only be issued to founders due to timing and pricing issues associated with issuing the Series FF, other employees may be upset that founders are receiving some liquidity.
  • There is some risk of claims against the founders that sell (and the board) if the company never reaches a liquidity event. The other stockholders (including disgruntled employees) might argue that the company should have issued new shares to the investors and received the funds that the founder received from selling the stock.
  • Despite carefully drafted releases, venture funds may reluctant to purchase the shares due to potential claims by disgruntled founders that they were forced to sell their stake at a low price compared to the price in an eventual liquidity event.

I am curious to see whether the Founders Fund has managed to invent something that will be broadly accepted or just a novel feature that is occasionally used by companies that have a connection to the Founders Fund.

I will likely update this post (without warning) with more thoughts as I hear feedback from various people.

Comments

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  • Bill Hunter

    Interesting analysis — the only thing “new” about this seemed to be the name and a way to escape the valuation of true common stock at the preferred price for the sake of keeping option strike prices cheap for employees.

    What if a founder is approached about selling common stock by a VC? Is there any way to do this without affecting the pricing of the rest of the common? Perhaps turning founder’s common into a new series of stock, and then assigning different right to that?

  • http://www.startupcompanylawyer.com Yokum

    If a company or a third party buys the common stock, that price is indicative of fair market value of the common stock for option pricing purposes. The Series FF is designed to solve that problem by allowing the Series FF to convert into the same series of preferred stock issued to investors.

    Generally, all shares of a series/class need to be treated equally. Thus, a special series of preferred stock is the mechanism for selectively allowing certain persons to “upgrade” their stock for sale to third parties.

  • Bill Hunter

    Agreed — that was what I assumed when I first heard of this concept. It seems, then, that all founders should start off with a different “series” of essentially common stock (call it FF, Q, etc). It solves the option pricing issue that would always otherwise arise. In most cases, assume the founders won’t cash out early, in which case this yields no difference, but should they do so, then this really yields them a much better return and still preserves better upside for employees.

    I can’t imagine any VC objecting to calling founders’ shares a different class with the exact same liquidation preferences, voting rights, co-sale etc of common. So it seems like this should always be part of the formula for setting up a company that is started without initial VC investment. Wouldn’t it make sense to always recommend this to a founder, then?

  • http://www.startupcompanylawyer.com Yokum

    The Founders Fund is trying to encourage use of Series FF. It’s too early to comment whether it has been accepted by VCs and sufficiently vetted by attorneys.

  • Jeff

    Bill – I think the issue with that approach is that if there is no real difference between the two classes of common stock – founders vs. non-founders, then there is no meaningful distinction for tax purposes. The Series FF though addresses that since the purchase has the bells and whistles of the new preferred issued in the financing so does have a distinction over the common (depending on the bells and whistles).

    One question that I have Yokum is when is this Series FF stock being issued? If the founders fund already has a relationship with the company at the time of issuance then aren’t there valuation/compensation issues? How does founders fund handle this vis a vis the timing of their investment in the funded company?

  • http://www.startupcompanylawyer.com Yokum

    In a perfect world, Founders Fund would probably want the Series FF issued upon incorporation. As a practical matter, in the situation where Founders Fund is first involved in the company at the time of a Series A financing, the founders will need to pay the Series A price for the Series FF in cash or via contribution of property, such as IP that was not already contributed to the company.

  • Sarabas

    Yokum, I am in the process of starting a company. My first round of funding will be a Series A where each share is priced at $0.40. My lawyer recommends that I first incorporate, wait for a month and then transfer to the company my IP/Software, etc. and also get the money from the investors so that it is easier to justify to the IRS the differential in price between the common stock (founders stock) and the series. I can not understand what he means…??

    Also I noticed that on your posting you mention: “Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). ” ……. “…founders stock is typically issued at a very nominal price per share, such as $0.001…”

    This is very confusing… A prompt response would be really appreciated.

  • http://www.startupcompanylawyer.com Yokum

    You really should ask your attorney to explain this better.

    Generally, founders want common stock issued at a very low price per share. Preferred stock is issued at a higher price per share. If you issue Preferred Stock at a high price on the same day that you issue common stock, there is a risk that the IRS might deem the issuance to the founder at a low price to be “income” to the extent that the price paid by the founder is less than fair market value.

    To alleviate this risk, we sometimes suggest waiting some time period before dramatically increase the price of common or preferred stock — so that there is some argument that the value of the company increased during that intervening time period.

  • Ty

    Yokum,

    The Series FF concept is interesting, but untried.

    I have a couple of questions based on your exchange wih Jeff above.

    First, it is still unclear to me what is the tax differences between common stock held by founders vs. non-founders using the Series FF. Jeff seems to imply that using the Series FF addresses some tax issue, “depending on the bells and whistles.” But isn’t the basis of the stock (either common or Series FF) the same? In other words, when these shares are sold, the tax consequences are still the same, right? Maybe I’m missing something here.

    Second, you note that “in a perfect world, Founders Fund would probably want the Series FF issued upon incorporation.” But let’s say the founders set up their startup with simple common stock. Several months later, when the company is still probably at the same founders’ valuation (because money has been burned but there is still no visibility about the business and prospects of success, and perhaps the founders inject more capital at the same original price), the founders decide to amend their articles to convert all of their common stock into Series FF. Then aren’t we still in the same boat?

    Can you by chance point us to where we can review the terms of the Series FF that has been used. Any of these articles accessible via the web?

    Thanks,
    Ty

  • http://www.startupcompanylawyer.com Yokum

    Ty,

    1. I will defer to tax experts, but I believe that there is an open question as to whether the sale of Series FF is capital gain.

    2. Once again, deferring to tax experts, I suppose if you did a “do over” on capitalization and treated all common/option holders equally, then the company could recapitalize to create common and Series FF.

    The certificates of incorporation for Delaware companies can be ordered from the Secretary of State. I suspect that anyone could review the Founders Fund portfolio companies and order the COIs.

  • Ty

    Thanks for your responses, Yokum.

    To be honest, I would be surprised if there is no capital gain on the sale because the tax basis for the founder has not changed. In other words, at least this is how I understand the tax rules, if I buy Series FF shares at 0.01 each and sell them at 1.00 each, then my gain is 0.99 each, even if the market value of the shares are 1.00 each.

    Having said that, given that I am a founder with a start-up that only has founder capital right now, it may make sense to convert all of our capital into Series FF type shares by changing the terms of our current shares, in case there indeed are positive tax benefits. Thanks!

    Regards,
    Ty

  • http://www.startupcompanylawyer.com Yokum

    To clarify, the gain may be ordinary income instead of capital gain. There are also other potential tax pitfalls that are open questions.

    Anyone seriously thinking about Series FF should have a long talk with competent attorneys (corporate, tax and employee benefits) about the benefits and potential risks (tax and other). This post does not attempt to explain some of the technical tax risks. I can’t currently say that I am comfortable recommending Series FF to companies. No one should assume that I recommend the practice simply because I’ve written about it.

  • Stefano

    This is interesting…

    We (founders) got common stock upon incorporation and I’m wondering if we should have done this instead. Too late now.

    We are doing a financing in the next few months and some VCs have offered to buy some of our common stock at 85% of the value of the preferred. We are cash flow positive and generally doing quite well. They have made this offer because we don’t want to raise that much money, and they are putting in less than they’d like. This way they get more.

    Is there a reason why the company can’t simply buy back the shares of some employees (or founders), using either our operating cash flow or proceeds from the preferred stock sale? Seems like it’s a better deal than having the VCs buy common stock directly, especially if it’s at a discount to the preferred price. It’s also a cheaper way of increasing the options pool. Our law firm is not very familiar with the practice. Just wondering how these things normally work or what options are out there…

  • http://www.startupcompanylawyer.com Yokum

    @Stefano – I really don’t think that Series FF is a good idea and generally discourage founders from implementing it.

    If the company has the cash (and would not be insolvent as a result of the repurchase), the company could repurchase the shares. However, venture funded companies may have protective provisions that prevent stock repurchases without preferred stockholder consent. In addition, if a founder’s shares are repurchased and the company later goes bankrupt, the other stockholders may have claims against the company, the board and the founder as the opportunity to sell wasn’t provided to all stockholders. Of course, mathematically, if shares are repurchased, the number of outstanding shares decreases and the percentage ownership of existing stockholders increases. This is a different result from a sale of shares from one stockholder to another. Finally, a purchase by the company of shares at presumably FMV will directly affect FMV for option pricing purposes. A sale between two non-director/insider shareholders might not affect FMV for option pricing purposes if the company has no knowledge of the price.

    If your lawyers aren’t able to articulate the differences, you probably need an upgrade.

  • VW

    Does angel investors or employees (common share holder and non-board) consider as insider shareholder? If so, their selling to third parties would readjust the option pricing? Do they or do they not need to report this back to the company ledger?