What are Preferred Shares?

March 30 2010 No Commented

What are Preferred Shares?

Angel investors are important capital sources for entrepreneurs, providing cash as debt, some of which may be converted later into equity, or more commonly to purchase equity interests in the company.  Seasoned angel investors favor funding seed and startup companies by purchasing preferred shares, rather than simply owning common (ordinary) shares or convertible debt (see: Angels: Convertible Debt Is Seldom the Right Security for Startup Investments and When is Convertible Debt the Right Instrument for Angel Investments?)

So, what is preferred stock?  Most corporations can issue multiple classes of stock, usually preferred or common shares.  With two classes of stock, certain rights can be reserved for each class, regardless of the relative size of each class.  Preferred shares of private companies usually have the right (or obligation) to convert to common shares at a prearranged conversion rate (usually 1 to 1), upon the occurrence of specific timing, such as the sale of the company.  Preferred stock also regularly has a stipulated dividend rate. 

Legal expenses are generally higher for establishing a preferred class of stock for investors, compared to issuing common shares or a debt instrument.  And, for smaller rounds of investment (<$250,000) it may be difficult to justify.  However, I still prefer purchasing a preferred security because it sets the stage for subsequent investors.  Investing in common shares, on the other hand, can create problems when subsequent investors demand preferred shares at the time of their funding.  Investor alignment is best accommodated when all investors own the same class of stock.

What are some of the specific advantages to investors for utilizing a preferred offering?  Stay tuned….

It’s a GREAT time to be an angel.  Find a group and jump in!

Bill Payne is the 2010 BNZ University of Auckland Business School Entrepreneur In Residence. www.billpayne.com