If you’re currently planning your fundraising strategy, you may be thinking of issuing preferred shares to investors. What are they, and how are they different from common shares? Why do investors like preferred shares, and what happens if your startup doesn’t have any? In this article, we’ll cover the basics of common and preferred shares in the context of fundraising.
What Are Preferred Shares?
When a startup is first incorporated, there are usually only common shares. The common shares may be bifurcated or trifurcated, meaning that they’re divided into different classes with different rights attached to them, but in most cases, the capitalization of the startup does not include preferred shares yet. Once entrepreneurs begin to fundraise, however, legal documents from investors may require that the startup issue preferred shares as a condition to closing.
So, what exactly are preferred shares?
No matter how many classes of common shares there are, they tend to have many similarities. For example, some classes may have more voting rights than others, but all the classes are entitled to vote on the same matters. Preferred shares, on the other hand, are in a world of their own, with rights that are specific to fundraising. For example, investors may demand a liquidation preference, which determines the order and amount of distributions upon a liquidation event. Preferred shares may come with or without voting rights, and the matters upon which votes can be cast are usually distinct from those for common shares. Essentially, preferred shares relate primarily to the investment operations of a startup, while common shares cover broader operations.
Why Do Investors Like Preferred Shares?
Typically, separate classes of preferred shares are issued for each fundraising round. These classes come with rights that are specific to the round, which are designated in a term sheet or private placement memorandum. Depending on the offering, the included rights can vary widely. Some offerings may be restricted to those that are commonly seen in shareholder agreements, such as drag-along rights, rights of first refusal, and information rights. In more complex offerings, they may include more “obscure” rights, such as the implementation of an executive education program or specific voting powers.
Because of the versatility of what preferred shares can offer to investors, most investment documents, including the Y Combinator SAFE, mention preferred shares as opposed to common shares. Preferred shares allow entrepreneurs and investors to conduct detailed negotiations on individual fundraising rounds without impacting the broader operations of the startup, which are covered by the voting rights attached to common shares. They allow investors to go deep into specific rights that may impact them the most. This is why many investors prefer to be issued preferred shares over common shares.
How To Create Preferred Share Classes?
Many entrepreneurs have asked me whether they should establish preferred share classes upon incorporation. The answer is no. Without having first negotiated and reached an agreement with investors on the rights that they want to see attached to preferred shares, you wouldn’t be able to issue the right type of equity to them. Even if you already have “blank” preferred shares sitting there, chances are, you’d still have to refile your legal documents to amend the rights attached to those shares after negotiating with investors. You can save yourself the legal costs by leaving the creation of preferred shares until you get to your first fundraising round.
If you’ve reached an agreement with your investors on the terms to be included in the term sheet, then you may file an amended and restated certificate of incorporation that includes the proposed class of preferred shares and the rights attached to them. This filing is often a condition to closing. Depending on the complexity of the negotiations, the new certificate of incorporation can be significantly longer than the original one. You may want to consult with a lawyer on drafting out the new terms.
In a Nutshell
First-time entrepreneurs may worry about whether the legal structure of their startups is conducive to fundraising and whether they should establish preferred shares upon incorporation. While having the correct legal structure at the outset is certainly important, it’s quite simple to change things up depending on your business needs. In a fundraising round, investors may demand something radically different from anything you could have imagined upon incorporation. Don’t worry about perfection too early on. Go with the flow, and you may be surprised at the directions that you’re taken.
