What is preferred stock and why is it issued to investors?
Takeaway: Preferred stock is a distinct class of stock with superior economic and control rights designed to give investors downside protection and a voice in corporate governance, a standard and non-negotiable requirement for any venture capital investment.
When your startup raises a priced round of financing from venture capitalists, they will not be buying the same class of stock that you and your employees hold. Founders and employees hold Common Stock. Investors purchase Preferred Stock. This is a fundamental and non-negotiable part of every venture capital deal.
Understanding the distinction between these two classes of stock is essential for any founder. The "preference" in preferred stock is not just a name; it refers to a bundle of special, contractual rights that give investors a superior position to the common stockholders. These rights are designed to protect their investment and give them a significant say in the governance of the company.
Why Not Just Common Stock?
A VC cannot invest in your common stock because their own investors (their Limited Partners) require them to have downside protection. They are investing a large amount of capital at a high valuation, and they need to ensure their investment is protected if the company has a modest or disappointing outcome. Preferred stock is the legal instrument that provides this protection.
The Core Rights of Preferred Stock
The special rights of preferred stock are formally written into the company's Certificate of Incorporation. While the specific terms can be negotiated, they almost always include:
A Liquidation Preference: This is the most important economic right. It means that in a "liquidation event" (such as a sale of the company), the preferred stockholders get their money back first, before the common stockholders receive any proceeds. This provides critical downside protection for the investors.
Anti-Dilution Protection: This protects the investors from dilution in the event the company raises a future financing round at a lower valuation (a "down round"). If a down round occurs, the conversion price of the preferred stock is adjusted downward, giving the investors more shares of common stock upon conversion to compensate them for the lower valuation.
Special Voting Rights (Protective Provisions): Preferred stockholders have the right to veto certain major corporate actions, even if they don't control the board of directors. These "protective provisions" ensure that the company cannot make a fundamental change without the consent of its investors.
Conversion Rights: Preferred stock is always convertible into common stock, typically on a one-to-one basis. This allows the investors to convert their shares to common stock to participate in the upside of a highly successful outcome, such as an IPO.
The issuance of preferred stock is what defines a "priced round" or a "venture financing." It is the standard, universal mechanism for structuring a partnership between founders and their investors, balancing the investors' need for protection with the founders' desire for growth.
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.