What is founders’ preferred stock?
Takeaway: Founders’ Preferred Stock—often called “Series FF Preferred Stock”—is a special class of stock designed to make early founder liquidity transactions easier and more defensible from a tax and accounting standpoint. It automatically converts into the latest series of preferred stock when sold in a financing, but its benefits are limited and not always embraced by investors.
In a typical startup, founders receive common stock and investors receive preferred stock. Founders’ Preferred Stock is a rare alternative structure that can be put in place at incorporation. Its purpose is not to give founders supervoting rights or liquidation preferences, but to facilitate cleaner, lower-risk early liquidity for founders in future financings.
How Founders’ Preferred Stock Works
Founders’ Preferred Stock is structured to automatically convert into the new preferred stock issued in a financing when sold by a founder to an investor. This matters because:
Tax treatment: If founders sell common stock at the same price as the new preferred stock, the IRS could argue that the “spread” above the fair market value of common stock is compensation (ordinary income), not capital gains.
Conversion feature: Because founders’ preferred automatically converts into the new preferred, the sale looks less like a transfer of hidden value by the company and more like a direct capital gain transaction, which strengthens the case for favorable tax treatment.
Valuation stability: Using founders’ preferred stock helps avoid artificially inflating the fair market value of common stock when founders sell shares in a financing.
Note: The favorable tax treatment is not guaranteed. The IRS and auditors may still challenge it, but practitioners generally view the automatic conversion feature as a stronger position than selling common stock outright.
When to Consider It
Founders’ Preferred Stock is most useful for:
Founders who anticipate raising venture capital and want to preserve the option for early liquidity.
Scenarios where avoiding valuation distortion or potential compensatory income treatment is important.
However, it has drawbacks:
Investor concerns: Some VCs dislike founders’ preferred stock, as it makes it easier for founders to sell shares early.
Repurchase limitations: If founders’ preferred stock isn’t subject to vesting, the company cannot repurchase it if a founder leaves.
Timing: If the company has already been formed and issued common stock, switching later can create tax issues.
Practical Features
Typically, only a portion of a founder’s shares (often no more than 25%) are issued as founders’ preferred, with the rest being common stock.
Founders’ preferred is often fully vested at issuance, though vesting can be added.
Best practice is to keep it free from transfer restrictions that would block secondary sales.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.