Don't give your investors common stock.
Keep it simple and separate – preferred stock for money, common stock for effort.
Tl;dr: Those who put in money get preferred stock. Those who put in effort get common stock. Mixing these two can result in inflated common stock prices and complicated corporate governance.
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We had to prepare custom paperwork…
The company had DIY-ed it. They had used online templates from questionable websites to prepare their incorporation documents and issue stock.
As a result, a handful of early investors had received common stock (along with generous helpings of anti-dilution rights).
They were now preparing for their first priced round, and given the way things had been done, the round was going to take longer and cost more than expected.
The investors had to be negotiated out of their anti-dilution rights,
They had to agree to have their common stock converted to preferred stock,
Custom paperwork had to be prepared for all this.
That was the part that could be fixed.
But there was another issue as well.
Common vs. Preferred: What’s the difference?
Fundamentally, ownership in a corporation is broken down into little bits called “shares”. But not all shares are created equal – there can be different classes and series of shares, each with important differences.
Classes of shares: Common Stock, Preferred Stock, etc.
A “class” is a category of shares. Different classes of shares normally have different rights. For example, Class A Common Stock may provide its owners with 10 votes per share whereas Class B Common Stock provides its owners with only one vote per share. Similarly, the owner of Preferred Stock may get to be paid out first in a liquidation, compared to the owner of Common Stock which gets paid out last.
Series of shares: Series Seed, Series A, etc.
A “series” is a sub-category of shares. Different series of shares normally have the same rights, but differ in terms of their economics. For example, Series Seed shares may have a liquidation price of $1 per share, whereas Series A shares may have a liquidation price of $1.50 per share (which, normally, is equal to the original purchase price of those shares) – and may be equal in all other non-economic respects.
Rights of Common and Preferred Stock
While the specific rights afforded to Common Stock and Preferred Stock differ from company to company, here are a few common themes which normally differentiate the two.
Liquidation preference: In case of a liquidation, preferred stockholders get paid out first, whereas common stockholders get paid out last.
Protective provisions: Preferred stockholders often have a “veto” right on certain fundamental corporate actions, such as amending the charter, issuing senior shares, or taking on large debt.
Anti-dilution rights: Preferred stockholders may also the right to maintain their equity percentage in a company in case the company’s valuation drops in future financing rounds.
Dividend rights: Preferred stockholders may be guaranteed certain annual dividends.
Board participation: Preferred stockholders may also have a designated seat(s) on the Board.
Why this difference?
From a corporate theory perspective, it boils down to those who invest their money (the investors) not having effective control over the fate of the company, which otherwise lies in the hands of those who invest their efforts (the management).
As a result, to “compensate” them for their limited control over the company’s performance, investors are allowed certain additional rights which, ultimately, are geared toward protecting their investment (for example, the liquidation preference and guaranteed dividends).
What’s so bad about giving investors common stock?
You may think, “hey, if my investors are cool with getting common stock, why shouldn’t I issue it to them instead of preferred?” There are two main reasons for holding your horses before you issue common stock to your investors.
1. It affects your stock price
Your equity is your company’s most precious resource – and your most potent tool for attracting and retaining top talent, in the form of employees, contractors, and advisors. However, in order to obtain that equity – through purchasing the stock or exercising stock options – your talent has to pay money to the company (or else pay tax on the income).
When you issue common stock to investors, you’re pegging the stock’s fair market value to your company’s venture valuation. So, if your company has a fully diluted capitalization of 10,000,000 shares and you issue common stock to your investors at a $5,000,000 valuation, the fair market value of your common stock becomes $0.50.
That’s exorbitantly high for an early-stage startup – 50,000 times more expensive than what the fair market value would be otherwise (around $0.00001).
What this means is that now, your hired talent has to pay 50,000x more for getting equity in your company (again, either in the form of a purchase/exercise price or accrued tax). Needless to say, they’re not going to like it.
Wouldn’t that be the case with preferred stock as well?
Nope. When issuing preferred stock in a priced round, you’re keeping the company’s venture valuation from “sticking” to the common stock. Instead, it values the preferred stock – and since preferred stock has substantially more rights than common stock, the latter’s price will be at a significant discount. This is why it’s normal for a company’s 409A valuation (which provides the fair market value of common stock) to be substantially less than the venture valuation of the company.
2. It affects your corporate governance
Normally, investors rights are provided in priced round closing documents, such as the Amended Charter, Investors’ Rights Agreement, Voting Agreement, and Right of First Refusal and Co-Sale Agreement. If all investors have the same class and series of stock – for example, Series Seed Preferred Stock – then these rights would be tied to that stock, making corporate governance simple.
However, if investors have different kinds of stock – for example, some have Series Seed Preferred Stock, whereas others have common stock – it would take additional layers of paperwork and wordsmithing to make sure that all the right people (the investors) got their proper rights.
The alternative would be converting the investors’ common stock into preferred stock, which would also mean additional layers of custom paperwork – and, hence, increased costs and delayed closing.
What should I do instead?
If you’re super early-stage and don’t have the round size or the resources to do a priced round, issue SAFEs instead. They’re the go-to fundraising instrument for pre-seed rounds. That said, do be mindful of their shortcomings (elaborated here).
Conclusion: Common for Effort, Preferred for Money
Here’s a simple rule of thumb to follow:
Those who put in effort get common stock (or stock options)
Those who put in money get preferred stock.
If you’re super-early, issue SAFEs instead of common stock, as they will later turn into preferred stock.
Startup Ecosystem Member Highlight
Over the past years, I’ve had the opportunity to meet with amazing people who are super passionate about startups. I’d love to introduce them to you through this newsletter, as they can be helpful to you as you start, grow, and scale your startup.
Meet Jonathan Engle
Jonathan is the co-founder and CEO of Startup Stack, a network which offers over $2,000,000+ in discounts across 200+ tech stacks for startups. The list is quite expansive and impressive – and it’s entirely available online for free for founders.
Jonathan and his team are on to something. Being a startup themselves, they know how difficult it is to operate in conditions of extreme uncertainty and limited resources, where you need all the help you can get in the form of tech tools. That’s where Startup Stack comes in. The next time you’re looking into signing up for a tool, check out their perks, and chances are they have something in store for you.
On top of this, Jonathan is also serves in the Utah Army National Guard. In fact, the first time we connected, we spent nearly the entire call talking about his fascinating work!
Connect with Jonathan on LinkedIn and check out Startup Stack’s offerings.
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Until next time!
Stepan
A bit about me: I’m a corporate lawyer with 10+ years of experience helping 100s of companies navigate the legal journey, including early-stage startups and unicorns. I quit my private practice to start Corpora and help founders raise money faster and more affordably. Let’s connect on LinkedIn.