Everything you need to know about Preferred Shares in Startups.

Your scroll down TechCrunch’s homepage as you sip your morning coffee – and BOOM! You see that your friend’s startup just raised a $50m from a top-tier VC. The VC will now own 20% of the company, approximately what your co-founder friend now owns.

Are those 20% stakes equal?

When startup founders raise money from investors, they’re basically selling shares of their company. They are looking to sell to people who want to invest in it. But not all shares are made equal. The shares that investors acquire are typically superior in some ways to the ones startup founders own or startup employees get (through their stock options). They are preferred to the founders’ and employees’ common shares.

So, what makes preferred shares preferred? In this post we’ll cover the main rights that investors gain when owning preferred shares in startups. Some of these rights are actual features of the shares and some are negotiated as a legal terms in a term sheet. Whatever way preferred shareholders get them, it’s important to know what they mean.

Protections Matter When You Need Them.

Before we start, it’s important to note that many of the rights and protections given (sold) to preferred shareholders in a fair negotiation are meant to protect investors and their investment in cases where the company does not meet its targets and does not create enough value. They are not there to give investors an unfair advantage over common shareholders. If the company shows explosive growth and hits a home-run exit, many of these protections may never get used. If the company doesn’t sell for a high enough price, these protections give its investors, the ones who actually poured cash into the company, priority over the founders and employees.

And with that, let’s run through the key terms.

Liquidation Preference.

A liquidation preference determines the order in which funds will be distributed in case the company is sold or liquidated. If the proceeds are not high enough to make investors convert their shares into common shares (more on that below), they will get their money back before any common shareholders get to participate in proceeds from a sale. If the proceeds from a sale are high enough to justify a conversion, the liquidation preference will not be used and investors will be treated as common shareholders, participating in the sale according to their ownership percentage.

The preference is expressed as a multiple of the investment (e.g. a 1x preference means that investors get priority on one-time their investment amount) and it can be participating or non-participating.

Liquidation preferences are considered by many as the second most important term (valuation is first) when raising money and are therefore heavily negotiated. If you want to learn more, read this.

Conversion.

Preferred shares are convertible into common shares. The conversion typically starts at a 1:1 ratio (one preferred share can be converted into one common share), but can change over time depending on how future financing rounds go. Investors will choose whether to convert their shares into common shares at the time of a sale[1] and based on whether they will make more money using their liquidation preference right or as a common shareholder.

For example, an investor invested $1m in a company for a 20% stake with a simple non-participating liquidation preference of 1x. Let’s assume the company sells for $3m, this investor is better off using her liquidation preference to get her $1m back (since $1m is greater than 20% times $3m), so she will not convert to common. If the sale price is $8m, then converting to common and collecting her 20% is a better result for her since $1.6m is greater than $1m. If the company is sold for $5m, she is indifferent ($1m = 20% x $5m). That indifference point is her equilibrium point. The point in which she will convert to common.

Board of Directors.

A company’s board can have a significant impact on its strategic direction and decision making. As such, investors many times require a seat on the board. While founders typically still control the board after the first or even second round of financing, it’s not uncommon for them to lose such control after later rounds.

Protective Provisions.

Protective provisions give investors a lot of power when it comes to major company decisions. These provisions require that preferred shareholders (or a certain percentage of them) approve big decisions or transactions like a sale, a liquidation, an equity round, changing the size of the board, raising debt, etc.

Anti-Dilution.

Anti-dilution rights protect investors in cases where the company has to raise more equity but does so at a lower price. The protection comes through an adjustment to the conversion ratio. This allows investors to get more common shares for each preferred share they own.

Preemptive Rights.

Preemptive rights allow investors to participate in future financing rounds, usually, these rights will be pro-rata rights. This means that investors get to acquire shares in a way that keeps their ownership percentage intact.

Right of First Refusal (ROFR).

This provision allows preferred shareholders to match any offer made to a common shareholder if the latter decides to sell his or her shares. If preferred shareholders match the price and other terms on such sale, they get priority over a prospective buyer.

Tag-Alone and Drag-Along.

Tag-along (aka “Co-Sale”) allows investors to sell their shares along with the company’s founders if the founders decide to sell a portion or all of their shares. This right gives investors the right to essentially exit along with the founders they invested in. Drag-Along allows the company to facilitate a sale without having to get literal approval from all shareholders through an agreement that stipulates that all shareholders must automatically vote in favor of a transaction if such transaction is approved by the company’s board.

Dividends.

Investors may negotiate that their investment accrues dividends (at a 5-8% rate) until it is repaid. Ultimately impacting how many is available to distribute among common shareholders.

Pricing of Preferred Shares in Startups vs. Common Shares in Startups.

The above rights and protections do not come for free. Preferred shares in startups can be priced 5-6 times higher than the price of common shares at the early stage of the company. This price gap decreases as the company matures and nears a successful exit.

Wait. Pricing of common shares? You just said investors invest in a company through buying preferred shares – so where does that pricing even come from? That’s a topic for another blog, but briefly – companies must get a third-party valuation of their common shares every 12 months (or if there’s a material event like a financing round). That value is used to determine the exercise price of the options companies give their employees. It’s not uncommon to see a company that raised a round at a price of $1.5 per preferred share grant options at 20% of that price.

Sum It Up!

Angel investors and Venture Capital firms pour billions of dollars into startups annually (see a short reminder on startups investing basics and understand why). These investments come with certain rights and priorities that protect such investors and their investment.

Try to think about (most) of these protections and rights like insurance. If you need to use them (company sells for a lower than expected price) you’re very happy you paid extra for them. But if you don’t (home-run exit), then having common shares may have been the more attractive option.

[1] If the company IPOs, the conversion happens automatically and there is no choice