Preferred stock is a flexible tool for structuring investments. In earlier stage financing transactions, preferred stock is often given to key investors. While the preferred stock is issued by both early-stage and mature companies, it is particularly important for lawyers representing startups to understand the basic features and rights of preferred stock.

When early-stage startups issue equity, the employees and founders typically receive common stock. Meanwhile, investors generally receive preferred stock. Preferred stock generally has significant rights that the common stock does not have. For example, the preferred stock generally comes with greater protections and economic preferences. The startup’s in-house lawyer needs to be knowledgeable about the characteristics of preferred stock in order to balance attracting investors with maintaining management’s control of the company.

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Purposes of Investing in Preferred Stock

In simple terms, preferred stock is a type of stock that offers shareholders different rights than common stock. Preferred stock entitles the holders to certain preferences and rights that are not available to common stockholders.

A company’s certificate of incorporation includes provisions to authorize the company to issue a specified number of shares of preferred stock. The certificate of incorporation will also set forth the specific terms of a series of preferred stock. At any given time, the company’s board of directors is granted the authority to fix the number, designation, and relative rights of each series of preferred stock.

The main features of preferred stock, which are discussed in further detail below, include dividend rights, liquidation preferences, redemption and conversion rights, and voting preferences. The rights and powers of a given series of preferred stock are set forth in a document called a certificate of designations.

An investment in preferred stock offers investors with fixed income returns and more stable valuations as compared with common stock. Preferred stock also provides its investors with the combination benefits of capital appreciation with downside protection.

Dividends

Preferred stock may, but is not required to, pay dividends to its investors. If the preferred stock provided for the payment of dividends, the dividend rate can be fixed or variable. Dividends can be paid in the form of cash, common stock, or additional shares of preferred stock. If the payment of dividends is in the form of additional shares, it is referred to as a “payable-in-kind” or “PIK” dividend.

Dividends can also be cumulative or non-cumulative. Cumulative dividends accrue or accumulate over time. Therefore, if a company misses a dividend payment, it is obligated to pay accrued but unpaid dividends before it makes any other dividend payment. If the preferred stock pays non-cumulative dividends, and the company misses a dividend payment, the amount is simply lost.

Liquidation Preferences

The liquidation preference dictates the payment order in the event of a company’s involuntarily liquidation, dissolution, or winding up of its affairs.

Before any distribution or payment can be made to the holders of common stock, the holders of preferred stock are entitled to be paid the liquidation preference, sometimes alternately referred to as the liquidation value. The liquidation preference is often structured as a multiple of the purchase price the investor paid for the preferred stock. The holders of preferred stock are also entitled to be paid all accrued accumulated dividends.

Once the liquidation preference is paid, the receipt of additional liquidation payments depends on whether the preferred stock is “participating” or “non-participating.” Participating preferred stock is able to participate on an as-converted-to-common stock basis in receiving the remaining assets of the company along with the common stock.

Redemption Rights

Depending on the circumstances, preferred stock may be redeemable on a mandatory or optional basis. Optional redemption often requires the payment of a premium if the preferred stock is redeemed before specific dates.

Voting Power

Preferred stock can come will super-voting rights, voting rights comparable to common stock, voting rights only for certain events, or no voting rights. In some cases, the preferred stock votes together as one class with the common stock. In other cases, the preferred stock votes as a separate class.

Conversion Rights

Conversion rights can be negotiated for preferred stock. Typically, it is structured so that the preferred stock is convertible into shares of common stock according to a particular conversion ratio. The conversion ratio can be either a fixed price per share or a floating rate correlated with the market price of the underlying common stock at the time of conversion.

To protect the value, the preferred stock can include anti-dilution adjustments. A full ratchet anti-dilution provision adjusts the conversion price by applying the lowest sale price. On the other hand, a weighted average anti-dilution provision takes into account both the lower price and the number of shares issued at the lower price.

Pre-emptive Rights

Investors in early-stage financing rounds of startups are often provided pre-emptive rights. These rights prevent dilution of investors’ proportional ownership interest in the startup during subsequent financing rounds. Pre-emptive rights can last for a fixed period of time or can remain open-ended. However, such rights will terminate when a startup goes public or if the preferred stock is converted, exchanged, or redeemed.