Most startups issue only common stock. But sometimes a startup will encounter a situation, such as raising capital, where having more than one class of stock is beneficial (or required). When startup companies raise capital through the issuance of stock, they typically issue “preferred stock” to their investors.

Definition of Preferred Stock

Preferred stock is a class of stock that provides certain economic and control rights and protections not given to the holders of a startup’s common stock (the founders usually hold the common stock). Hence this class of stock is “preferred.”

Typical economic rights of preferred stock include a liquidation preference, anti-dilution protection, and conversion rights. Control rights deal with a host of voting issues and electing the board of directors.

Which Investors Receive Preferred Stock?

Preferred stock is most commonly issued when a startup undergoes a large financing, such as one with a venture capital fund. Angel investors and the friends & family round may sometimes receive preferred stock. Keep in mind there is no bright-line rule when it comes to angels and the f&f round.

Other than the Capital Raised, Does the Startup Benefit from the Issuance of Preferred Stock?

It sure does. Since preferred stock comes with economic and control rights and protections, common stock typically gets a lower valuation for the purposes of stock option grants or share issuances to the corporation’s employees. Employees can generally exercise their common stock options at a lower price than the price of the preferred stock. Thus, employees may feel as though they are receiving some sweat equity for their contribution to the corporation.

Imagine that you are just getting settled at your startup and decide a little extra capital could help your startup set the world on fire. So you approach your friends and family about investing in your startup company. Everyone turns you down, except for your Uncle Steve who can’t wait to invest in the next Facebook.

But little did you know that Uncle Steve subscribes via RSS to VentureBlog and follows Brad Feld’s tweets. Thus, Uncle Steve doesn’t want mere common stock but rather desires to be issued preferred stock. You were prepared to issue preferred stock to venture capitalists, but what do you do with Uncle Steve?

Issue Uncle Steve a diluted ‘Series A’ preferred shares. While you can oblige Uncle Steve’s risk tolerance through various economic, control, liquidity, and management terms with the preferred stock, the most important thing to do is maintain the ability to raise future venture funds. Limit shareholder rights (tag-along), keep a basic liquidation preference, think about a drag-along provision, etc. It’s OK to let Uncle Steve get some preferred provisions, but it can’t become an obstacle to future financings.