What is preferred stock and why is it issued to investors?
Takeaway: Preferred Stock is what venture capital investors in a priced equity round expect to receive when they invest in startups. It has certain rights, including a liquidation preference and voting rights, that the Common Stock does not have.
Venture capital (VC) investors play a critical role in the growth and development of startups. In exchange for their investments, VC investors often receive a specific type of equity called preferred stock. In this post, we will explore what preferred stock is, why it is issued to venture capital investors, and how it differs from common stock.
What is Preferred Stock?
Preferred stock is a unique class of equity that grants its holders certain advantages over holders of common stock. These advantages typically include dividend preferences, liquidation preferences, and, in some cases, voting rights. Preferred stock is often used to attract investors who seek a higher level of protection and priority over other equity holders.
Why is Preferred Stock Issued to Venture Capital Investors?
There are several reasons why startups issue preferred stock to venture capital investors:
Liquidation Preference: One of the main reasons preferred stock is issued to VC investors is the liquidation preference, which gives preferred shareholders priority in receiving proceeds from a liquidity event, such as an acquisition or initial public offering (IPO). This preference helps protect VC investors' capital and provides a greater level of assurance that they will receive a return on their investment.
Dividend Preference: Preferred stockholders usually have a dividend preference, which entitles them to receive dividends before common stockholders. While dividends are not always paid by startups, having this preference can provide VC investors with additional income if the company becomes profitable and decides to issue dividends.
Convertibility: Preferred stock is often convertible into common stock at the option of the holder, which provides VC investors with the flexibility to convert their shares into common stock when it is advantageous to do so, such as during an IPO or when the value of the common stock has significantly increased.
Voting Rights: Preferred stock typically includes voting rights including over certain corporate actions, giving VC investors a greater say in the company's strategic decisions and governance.
Enhanced Negotiating Power: Issuing preferred stock to VC investors can help startups negotiate better terms during fundraising rounds, as the preferred stock's features can be tailored to meet the specific requirements and risk tolerance of the investors.
Preferred Stock vs. Common Stock
Preferred stock and common stock are the two primary types of equity issued by companies. While both represent ownership in a company, they have some key differences:
Dividends: Preferred stockholders have a priority claim on dividends, while common stockholders only receive dividends after the preferred stockholders' claims have been satisfied. In practice, dividends are rarely issued by startups.
Liquidation: In the event of a company's liquidation, preferred stockholders have priority in receiving their investment back before common stockholders.
Voting Rights: Common stockholders typically have voting rights, whereas preferred stockholders may or may not have voting rights, depending on the terms of the preferred stock.
Convertibility: Preferred stock is often convertible into common stock, providing investors with the flexibility to convert their shares under favorable circumstances. Common stock is not convertible into preferred stock.
Conclusion
Preferred stock is a critical component of venture capital financing, offering VC investors a higher level of protection and priority compared to common stock. By understanding the features and benefits of preferred stock, startups can better navigate the fundraising process and establish strong relationships with their investors. Issuing preferred stock can be a powerful tool for attracting the necessary capital to fuel a startup's growth while balancing the interests of both founders and investors.