Seasoned Angel often Favor Preferred Shares

April 7 2010 No Commented

Seasoned Angel often Favor Preferred Shares

Professional investors, angels and venture capitalists alike, often stipulate that companies in which they invest establish a second class of stock (preferred, in addition to ordinary or common shares) and that the investors then purchase preferred securities.  What are the advantages to investors of preferred shares?

  • The shareholder agreements can stipulate that a majority of each class of stock approve significant activities, such as additional sales of stock, significant bank (or other) debt, mergers or acquisitions of other ventures, a trade sale of the company, an IPO or other actions.  Under these terms, preferred shareholders, regardless of their percentage ownership in the company, have a voice in major transactions subsequent to their investment.
  • If agreed upon at the time of the investment, the preferred shareholders can elect one or more directors and have a voice in the size of the board of directors.
  • Certain rights can be reserved for the preferred shareholders, such as:
    • A liquidation preference – in case of liquidation, the capital of the preferred shareholder is returned in full before distribution to common shareholders, regardless of the percentage share ownership of each.
    • Anti-dilution rights – if the company later accepts investment at a valuation lower than at the time of their earlier investment, the earlier shareholders are compensated with more equity, thus precluding excessive dilution.
    • And a myriad of other rights reserved for preferred shareholders, possibly including “redemption” under which the entrepreneur could be forced to repurchase investors shares after several years if progress towards an exit is unsatisfactory, or a “drag along” under which any offer to sell the company acceptable to the preferred shareholders can be used to force the entrepreneur and other common shareholders (or minority preferred shareholders) to sell under the same terms and conditions.
  • In the US and other jurisdictions, common or ordinary shares in a startup company with little or no revenues can be priced far below the price of the preferred shares at the time of angel or VC investment (and thereafter).  For example, if investors purchase preferred shares at $1.00 per share, the board could determine (after appropriate consideration) that the value of the common shares is only $0.10 to $0.20 per share.  This is very useful in establishing an options pool for officers and directors.  Offering valuable stock options to potential executives can be a quite valuable recruiting (and retaining) tool for building a high quality management team.

 In this post, we have only scratched the surface of the terms and conditions involved in a preferred offering for investors in a startup venture.  Entrepreneurs and investors are encouraged to seek professional counsel while negotiating the terms and conditions of such transactions.

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.