A Brief Guide to Preferred Stock, Part I

Preferred stock in a corporation is a series of stock that carries with it special rights and privileges for the holder. In terms of a company’s investment hierarchy, preferred stock is above common stock, but below debt instruments (e.g., notes, bonds, etc.) in terms of priority of payment.

The special rights afforded by preferred stock can include things like certain voting rights in a company, preferential dividends, and preferential returns upon liquidation. Preferred stock is normally reserved for significant rounds of funding for a company, and are usually issued to major angel, venture capital, or private equity investors.

Preferred stock can include a wide-variety of rights and privileges. There are several different components that may be used in the creation of preferred stock that are used to achieve varying goals and purposes. In Part I of this two-part blog, we’ve detailed some (but not all) of the common features and variations of preferred stock.  These are also the features that typically get negotiated in a financing “term sheet.”  Of course, it’s important to discuss these features with a qualified attorney before agreeing to a term sheet.

Liquidation Preference

In the event of the company’s liquidation, dissolution, or winding up, the liquidation preference aspect of some preferred stocks gives the holder the right to be paid the liquidation value of his or her shares before any payments can be distributed to those who hold common stock (or other junior securities) in the company. Liquidation preferences can be any multiple of the amount invested.  So, for example, a “1X” liquidation preference means that the preferred stockholders would be entitled to receive the amount of their investment back first before other junior securities could receive distributions.  Likewise, a “2X” preference would provide the preferred stockholders two times their investment back prior to distributions being made to junior securities.  

Anti-Dilution Rights

Preferred stock often includes “anti-dilution” protections. This means, if certain circumstances occur (e.g., the company issues parity or senior stock at a price lower than the price offered to preferred stockholders), then the anti-dilution component of the preferred stock will provide for appropriate changes in the amount of shares to be issued to preferred stockholders and the conversion price or ratio for the preferred stock. Additional shares are issued to existing preferred stockholders so that the percentage of the preferred stockholders’ ownership isn’t diluted.

A “full-ratchet” anti-dilution provision will reset the conversion rate to the lowest price of subsequently issued stock without regard for the number of stocks issued at the lower price. It will also provide for the issuance of additional stock to the preferred stockholders, as if they originally purchased the stock at that lower price.  

A “weighted average” anti-dilution provisions will account for both the lower price and the number of stocks issued at the lower price. The adjustment to conversion prices and the amount of additional shares to be issued to existing preferred stockholders is generally less severe than under the “full-rachet” provision.

Voting Rights

Preferred stock typically permits the holders to to vote on equal footing with the common stockholders.  But, often, the preferred stockholders may be granted additional voting rights (or veto rights) on certain events or decisions (e.g., sale of the company, incurrence of indebtedness beyond an acceptable amount, issuance of senior stock, etc.). These additional voting rights are meant to serve as a protection for holders of preferred stock if the company proposes to take any extraordinary corporate actions.

Companies can choose what types of superlatives and privileges accompany ownership of preferred stock, so the above list is not all-inclusive of every possible variation of preferred stock. Be sure to check back next month when we will continue this two-part blog series and detail some more important components and variations of preferred stock. If you have questions about issuing preferred stock or investing in a company with preferred stock, please contact the Doida Law Group to learn more.

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