Classes of Stock and Preferences

I am not a lawyer, an accountant, an SEC licensed anything, or a real expert in this field. Having said that, I have been involved in setting up classes of stock, preferences, and similar matters for many companies by now. So these are the things I have discovered over time so far. This discussion is about private equity, not public companies, which is a whole different world.

What are the preferences?

As far as I can tell, there is no way to tell all the possible preferences that can exist. In essence, as long as it's not illegal or restricted by regulation, a preference can be contractually defined to be anything the contracting parties wish. You could probably have a preference that the CEO will personally go to a particular homeless shelter each week and wash the feet of all the people in the lunch line. Of a CEO might not be willing to sell you those shares under that condition.

I have personally seen the following types of preferences in actual investment instruments:

• Restriction on exercising of rights: Dates, time frames, and other similar restrictions on exercising various rights, such as delay before sale after a transaction, timing of purchase of additional shares, and interest and discounts associated with such actions.
• Voting rights: This can include the right to vote (or not) in what proportion to shares held. Typically, this may include non-voting, proportional voting rights, disproportional voting rights, or limited voting rights.
• Dividends: The right to minimum dividends, dividends in proportion to profits, excess dividends over other shareholders, cumulate dividends across years when inadequate profit if available in a given year, or no dividends.
• Dilution: The stock is dilutive or not with what manner of dilution under what conditions, and other dilution protections such as right of first refusal and loan guarantees.
• Purchase additional equity: Purchase of additional equity as authorized, for example, to stay in proportion against dilution, or right of first refusal for further rounds of financing.
• Board membership: The right to appoint a board member, either by an individual investor or a group of investors.
• Liquidation preferences: The right to be made whole at liquidation prior to (and after) other classes of stock and debt holders.
• Sale, buy-back, restrictions, and rights to transfer: The ability to sell your stock to others or have your stock bought back by the company and right of first refusal for such, and the rights of the company to buy back stock at a price at a time.
• Financing restrictions: Right of first refusal on loans by providing loan guarantees, limits on investments from foreign or other entities, or other similar restrictions on financing.
• Drag-along and syndication: The right to sell equity under equivalent terms and conditions to other shareholders when others sell their stock, and the right to syndicate the investment in or with a group.
• Right of first refusal on sale: The right to buy anything the company sells at the same price as anyone else is offering it for.
• Limited ownership: Who may own each class of stock and who may not (e.g., founders or employees, etc.) and what happens when these conditions are no longer true.
• Conversion and multiple classes: Conversion to other classes of stock under what conditions and rights to buy proportional amounts of different classes of stock.
• Inspection, surveillance, and reporting: The right to physically and otherwise inspect facilities, books, accounts, and other details, access to information and people, seek advice from 3rd parties, and get reports on aspects of the business on varying schedules or other terms.
• Warrants: The ability to purchase additional stock at a strike price over time.
• Price: Different preferences can be parts of different classes of stock and be sold for different prices and those prices may change with time.

Classes of stock

Typically, classes of stocks are listed as Class A, B, etc. But as I understand it, the name of a class of stock has nothing to do with the preferences, or at least it doesn't have to.

• People typically identify Class A with Common stock (usually no preferences, voting rights proportional to number of shares, dividends if provided after preferences, last to liquidate, can buy or sell at will, dilutive).
• Class F has apparently become popular as "founder" stock with preferences (e.g., 10* votes proportional to number of shares, preferred cumulative dividends, can only sell to other founders, convertible to common, first in liquidation, dilutive).

Different classes of stock can also be bought and sold at different prices. A reasonable valuation for a company that has recently sold equity in all of its different classes would/could/might be the sum of the sale price times the number of issued shares of each type.

However, when you sell equity in a private growth company, you are selling the promise of future value, not necessarily what the last folks paid for it. But if you offer the same thing to different people at different prices, they may be very unhappy, and they may have a right to sue. My understanding is that you have to disclose the history of such transactions to the extent they effect other people.

Shares are prorated ownership of the company, but as these various rights come into play, things get complicated, and of course lacking voting and other similar rights creates inequities that, if they become too extreme may result in legal actions.

But as I say, there are apparently no hard and fast rules. So what this means is you have to read the subscription agreement, identify, and properly understand the preferences in place.

A few examples

In any contract, parties are taking risks for rewards. Preferences are negotiable aspects of contracts between the parties. Who goes first, who pays before or after the other performs, how the exchanges take place, etc. are all more or less important to different parties because of their perspectives.

• In our contracts with early stage companies we are putting in our time, expertise, reputations, capabilities, technologies, content, connections, and know how. In most cases, early stage companies don't have the money required to pay of for those services with cash. Instead, they offer us equity and (partially) deferred compensation. We are betting some of the most valuable things we have that we can help grow your company. We aren't betting the lives of our family members of course, but if we don't succeed enough, we are betting our relationships.

• If a company can pay us in cash, we will work for fees - up to an extent. But companies who cannot pay us in cash (checks will do too), have to trade some things because we only succeed if you succeed. Here's what we want (it's in our agreements):

  • Non-dilutive equity: We want a relatively small portion of the ownership that cannot be diluted by future investments. That's because we have seen enough history to know that we could work with you for years and be diluted to the point where we aren't paid enough to make it worth our time, even if you are wildly successful. We are taking risks so early that the dilution by the time of exit could be 100 to 1 or more. In that situation, each 1% of your company before dilution could end up being 0.01% at sale. If the company was sold for $1B after 5 years, that would translate to only $100,000. The average exit is more like $50M in a longer time frame, so we could end up with $5,000/% for years of effort and all the other things we bring. We also advise founders to have small amounts of non-dilutive equity, and to answer the next question, as long as it's not too much of a percentage of the company, serious future buyers are not likely to complain. And of course if they bring enough money, you can sell them some small amount of non-dilutive as well.

  • Payments as and if you start to succeed: Once you start to bring in enough cash to afford to pay us, we what to transition to being paid for our time like anyone else. And once you start to succeed to this point, you would likely rather pay us cash than keep giving up more of your equity. The only real question is at what point in your cash flow that is. So we negotiate it with you for your business.

  • Unrestricted sale or transfer of our equity: We want the right to sell our equity as and if we wish. This doesn't hurt you, but it helps us. So why not?

  • Drag along rights: We want to be able to sell our equity to buyers who are buying equity from larger shareholders under the same terms and conditions, if we choose to do so. This prevents the big shareholders from making a sweetheart deal that screws the rest of us shareholders, but it does no harm to a legitimate sale of equity by major shareholders. And of course you might want us to help you negotiate these deals to get the best price and understand the implications of the sale.

  • Purchase rights of first refusal: We want to be able to purchase anything the company sells (including equity) for the same price as any other buyer. Our money is as good as anyone's and there is no legitimate reasons I can think of to not let us buy things instead of someone else. On the other hand, it also keeps folks from selling to their brother-in-law for way below market value, and stops any attempt at extortion from being able to succeed legally. Of course most extortion is illegal, but that's another issue.

  • Any other rights other shareholders have: It's a matter of principal that if someone else gets some right, we should have it too. After all, why are they better than us? OK - there may be some legitimate reasons, such as someone putting in a lot of money and demanding a board seat. We don't particularly want a seat on the board (we don't want the fiduciary duties that go along with it) and we will be happy to give up that right when the time comes in most cases, but still it's good to be asked.

• Some of the investors we bring to companies work with us to help them make better decisions about future tranches and to make sure they have good information about the companies they invest in. In this case, they require that the company retain us as advisors and that we have rights to access and information that we can share with them. Here are some of the preferences of their investment agreements:

  • Required use of advisory services: These investors will require that you engage an advisory service (ours we hope) and actively use it to help grow your company. This has several aspects to it, including (1) the belief on their part that you will do better with our help than without it, (2) it includes the use of metrics that we provide and that allows them to compare investments across their portfolio for better decision-making, (3) it provides expertise the companies may lack and independent opinions to help CEOs explore more options than they otherwise might be exposed to, and (4) they know and trust us more than they know or trust you, so they can reasonably rely on us to look out for their interests, which are aligned with yours.

  • Access to information and inspection: Part of the deal is that they have access to internal information others would not have. This includes financial information and projections, but also the facts on the ground. Many companies try to hide the "sausage making" from the investors, but these investors want to know when things could go right or wrong so they can keep making good judgments about investments. They typically get this information through the advisory services in the form of periodic (quarterly and/or monthly) reports, including metrics, financial, and legal updates. They want us to be working closely with you so they have clarity around what is really happening.

  • Right of first refusal on future financing: This is their version of protection against dilution. Instead of non-dilutive equity, they want to right to finance the future of the company. This has several major advantages for the company and the investor. With financing secured, the CEO no longer has to go out looking for money all the time and can spend their time growing the company. All they really have to do is set reasonable milestones each quarter and meet or exceed them. The advisory service helps them do that in such a way that the investors know and agree to what constitutes 'reasonable' and there is little or no disruption on either side. The investor gains the assurance that they will not have their interests diluted, and may even grow their interests through future investments, unless they decide not to invest (or otherwise finance) further, in which case they may get diluted.

These examples of preferences and the reasoning behind them should help understand the exchange that gets negotiated in preferences for investments. But do you really understand the implications of these things? Of course nobody knows everything about what the future may hold, but there is sometimes a lot of subtlety in negotiations of this sort, particularly when it comes to the effects of these decisions on the future value of the company to the different parties.

A call to action

We help grow companies!

If you want us to help you develop your strategy for preferences and classes of stock and equity, we do that as part of our advisory board service and in workshops. If you are enthusiastic about getting and receiving help, embrace the help we can provide.

We offer FREE resources! Use them!!

Want to do a presentation and see if we can help you further?

But consult your SEC licensed securities law firm before you make any actual decisions about legal issues such as these.

Next month... Dilution!!!

The discussion of equity, preferences, investment instruments, etc. is really more meaningful in the context of the issues of dilution. So make sure to read next month's article when it comes out to get the rest of this picture.

In summary

Now that you know more than I do about this subject, check with your lawyers and send me updates so I can find out what I got wrong here and how to fix it...

We are all learning all the time.