Raising new capital requires a strategic approach to attract would-be investors and help entrepreneurs bring their dreams to life. Startups fail for many reasons: competition, flawed business models, pricing and cost issues, mistimed products, or a dozen other reasons. But the leading cause is running out of cash. Preferred stock can help.
Over 25% of startups never receive the funding to launch and 38% fail because of a lack of funding.
Startups raising in excess of $1-2 million dollars will often be doing so by issuing some form of preferred stock.
What is Preferred Stock?
Investors who own a startup’s stock have equity in the company, which they can sell off in the future if they wish. Preferred stock is a priority form of ownership, allowing stockholders to enjoy:
- Special privileges
- Reduced risk
- Special rights
Investors putting substantial amounts (more than $1 million) into a startup generally want the greater rights and privileges that preferred stock brings.
Terms are negotiable, which is why working with an attorney who has experience drafting a term sheet and negotiating preferred stock financings is in your best interest.
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Paul is great. He talks things through with you, explains everything in detail and is very thorough. He always responds in a very timely manner. We at The Grocery Runners could not be happier!- Former Client
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Does Preferred Stock Have Voting Rights?
Yes, preferred stock typically does have voting rights, and it is also common for certain corporate transactions to require the approval of the series seed stockholders voting as a separate class. This gives the preferred stock investors veto power over certain transactions.
Who Receives Preferred Stock in a Startup?
Preferred stock is issued to investors. Founders generally do not get preferred stock at the time of incorporating. Instead, they receive common shares. However, we often recommend that founders take a SAFE or convertible note if they are putting money into the corporation to keep it afloat during the early months or years. That way, when the startup finally does a preferred stock financing, the founder’s SAFE or convertible note will convert into the preferred stock, giving the founder a taste.
Founders sometimes create a class of stock called founder preferred stock, which is a special class of stock that gives founders an opportunity for liquidity when it does a preferred stock financing later.
What Are the Benefits of Preferred Stock to the Investor and the Startup?
There are several advantages to offering preferred stock for both startups and investors. For startups, offering preferred stock is a great way to attract venture capitalists. Generally speaking, preferred stock is an attractive option for investors.
For investors, advantages include:
- The price per share is clearly defined from the start
- It starts the qualified small business stock (QSBS) countdown right away
- Preferred stock often comes with board rights, as well as voting rights
- Investors get liquidation preferences and may get anti-dilution protection
- Preferred stock may have advantageous dividend rights
Issuing preferred shares also comes with flexible terms that the startup can negotiate. If the investor agrees to the terms, and it’s common for negotiations to take place, this is a benefit for management.
You can customize the terms of preferred shares in ways that are not possible with common stock.
The terms are often complex, and without the help of an experienced lawyer who helps startups through negotiations, you may be agreeing to unfavorable terms that could harm your business in the future.
How Does Preferred Stock Compare to SAFEs And Convertible Notes?
SAFEs and convertible notes are generally used in smaller financing rounds, particularly when it is very difficult to put a valuation on the company. Convertible notes and SAFEs convert to preferred stock in the future. Preferred stock is used when the investment amount is larger, and when it is possible to put a valuation on the company.
How Can Kinetic Law Be Helpful in Startup Financing with Preferred Stock?
At Kinetic Law, we help startups navigate the complexities of startup financing, including preferred stock.
Our founder, Paul Spitz, is a former CEO and understands first-hand the challenges entrepreneurs face when launching and growing a startup.
If you are considering offering preferred stock to investors, it is crucial to ensure that preferred stock agreements are carefully negotiated and drafted properly. We have extensive experience guiding and advising startups through this process.
Our firm is situated in Cincinnati, and through our virtual services, we can assist clients throughout Ohio and California, including San Diego, Los Angeles, the San Francisco Bay Area and Silicon Valley.
Contact us today to schedule a consultation and see how we can help your startup offer preferred stock.
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