What Is Preferred Stock And Why Is Given To Investors?

What is preferred stock and why is given to investors? You’ve got to know your stocks and shares as a startup founder. This is especially true when it comes to giving equity and issuing stock. 

Unless you thrive on legal and math, this part of the startup game can seem really confusing at first. If you skipped this class in business school, it’s time for a quick tour of classes of stock, and the difference they can make when it comes to startup fundraising.

For the creative entrepreneur, this can seem about as fun and unsexy as accounting at first. However, knowing your classes of shares can quickly make all the difference in various outcomes, and certainly in what you get out of the ride of this venture.

Those who do take the time to familiarize themselves with this part of being a startup can find it gives them a great advantage in negotiating and achieving a desirable outcome. 

Why You Need To Know Your Stocks

If you are wondering what is preferred stock and why is given to investors you need to know that the truth is that you can do everything else perfectly and still end up with an outcome you are kicking yourself for unless you know this part of starting and operating a startup. 

What you do with your equity, shares, and ownership splits right from the beginning can really make all the difference in your ability to startup fundraising, recruit talent, grow, and actually create a profitable venture for yourself. It can directly inhibit or enhance your ability to make decisions and to have the impact you set out to have.

When it comes down to fundraising keep in mind that it is all about storytelling. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

What Is Preferred Stock?

When figuring out what is preferred stock and why is given to investors you need to keep in mind there are two main classes of company stock:

1. Common stock
2. Preferred stock

Common stock is well, common. It’s what you might be used to in investing in most publicly traded company stocks.

Some major shares are split between preferred and common too. One of the most notable is Warren Buffett’s Berkshire Hathaway shares. There is a massive difference in their pricing. Preferred is the most expensive. 

As the term suggests, preferred stocks give shareholders preferential treatment. Put simply, they get paid first, before anyone else. 

Why Investors Want Preferred Stock

If you are fundraising for your startup, investors will almost invariably demand preferred stock. This is a key factor when addressing what is preferred stock and why is given to investors.

The most obvious reason for this may appear to be their preference in getting paid first. You as the founder and any other common stockholders aren’t entitled to a penny until they have been paid. 

This applies to both dividends and to capital in a liquidation or M&A event. If there aren’t enough dividends to go around, they get them. If you sell your company, they get paid back their capital and any accumulated interest first. If you go bankrupt or close the doors, they are entitled to recoup their money from the sale of any assets before anyone else.

This might seem tough, but as a founder, it is a great way to motivate investors to fund you. It shows that you believe in your venture strong enough that you are willing to give them the first profits and ensure they get paid before you take any money. It is a way to build their confidence in you. 

However, there is another reason investors prefer to preferred stock too. It motivates the founders and other shareholders to shoot for a really big exit. How you negotiate an acquisition also makes all the difference but in the end the bigger, the better it can be for everyone. 

Preferred private stocks may also be taxed differently, and give investors a better net outcome as well.

Preferred Private Stock As Part Of An Investment Portfolio

Preferred stock in private companies is playing an increasing and increasingly important role in investment portfolios. This isn’t just true of various funds, but also angels and sophisticated individual investors as well. 

• The preferred stock offers better yields and more upside potential than bonds
• Preferred stock is much safer than common shares of a public company
• Preferred stock can be more liquid than real estate or gold

As a part of your investment portfolio, preferred stock can offer high yields, incredible growth potential, and dividends. Smart, well-placed investments can also offer greater security than other types of investments.

The Pros & Cons Of Preferred Stock

To truly address what is preferred stock and why is given to investors, note there are advantages of offering preferred stock to investors. Most obvious is actually gaining investors to make a bet on you, and getting the capital you need. 

However, there can be cons too. Specifically for the founders of a startup, and other early team members or advisors who may have stock and options. 

The biggest risk is that founders and other common shareholders may get nothing. Even in a large exit, or when selling a business for a billion dollars. If preferred stockholders also have high liquidation preferences, they can be due multiples of their initial investment, plus original capital, and any other promised earnings, all before any other shareholders, including the founders, get a dime. It happens.

Make sure you have a specialist attorney take a look at all of the fine print for you. Make sure you know what all of the terms mean, and the financial impacts of various scenarios. It’s worth running some financial models on what your net outcome may be given different situations. 

Along with these liquidation multiples, there can also be special provisions such as super-voting powers that you can use or be a victim of, and anti-dilution clauses. 

Summary

As a founder of a startup, you can expect investors to request preferred stock. It’s pretty standard. However, it is also important to watch out for other accompanying clauses which may dramatically impact your operations and anticipated exit. Know your classes of stock and math to ensure you are going to get out what you expect for the investment and work you are putting in.

Hopefully, this post provided some guidance when wondering what is preferred stock and why is given to investors.

In the video below I cover in detail what are preferred shares which you may find interesting.

FULL TRANSCRIPTION OF THE VIDEO:

Hello, everyone. This is Alejandro Cremades, and today we’re going to be talking about what are preferred shares? There are different types of shares that you are going to have to encounter when you are a startup founder. You’re going to have the common, you’re going to have the preferred, but what are the preferred shares, and why are they given to investors? In today’s video, we’re going to cover it, we’re going to break it down for you, and we’re going to give you all the insights. So, with that being said, let’s get into it.

Knowing your stocks and the types of shares is critical because it’s not only about the type of exit that you’re going to do, meaning who is going to acquire your business, and what type of acquisition that’s going to be. But also, what’s going to be your personal exit because, in many instances, you see so many companies that have raised so much money, but the founders end up with absolutely zero. 

You need to be very careful and structure things the right way so that you don’t end up stuck holding the bag. That’s why you really want to know your shares and understand the different classes, and in this case, why the preferred shares are so critical.

In terms of what are preferred shares? You’re going to have two types of shares essentially as a startup founder. You’re going to have on one end, the common shares, which are the ones that you give to founders, to the team, to directors, to advisors, and then you’re going to have the preferred shares. 

The preferred shares, in a sense, they are given to the outside investors that are coming in and making an investment in your business, and in essence, just like the name suggests, those investors will get preferential treatment. The types of classes of shares that you have play a critical role when you are getting your business acquired, especially if the valuation of the business is lower than the last valuation on the last financing round that you did.

Obviously, the higher the valuation, they’re good for everyone, and everything is fantastic. Everyone is happy, but when you’re selling the business for a lower amount, based on the valuation that you did on your last round of financing, investors are not going to be happy, and the types of classes of shares that they have are going to determine where they are in the line in order to cash out as investors.

In terms of why investors want preferred shares, it’s very simple. They are investing in the business, and they’re hoping to get a return over the course of time, and the way that you can negotiate an exit is going to determine how they can do and how many returns they can get for that investment that they placed. 

The way that you can negotiate an exit, an acquisition, a secondary sale, an IPO is going to determine what they can take out, and that’s why the preferred shares give them the preferential treatment that gives them that peace of mind of knowing that at least if you do a poor job, as least they can take the money out of the equation before you’re able to cash out yourself with the other common shareholders. That’s why the preferred shares are something the investors really want just for peace of mind, especially when cashing out.

When you are choosing a type of shares that you are going to be giving to investors, you’re going to need a corporate lawyer there reviewing everything to make sure that nothing is going to come and bite you because those preferred shares, in many instances, they come with liquidation preferences meaning that maybe they get two times or three times or whatever that is, the amount of money back before you ever get the opportunity to cash out. 

Let’s say, imagine they get 2X liquidation preferences, and the company gets acquired for maybe $20 million. The last valuation you did was around $10 million. Then, they get double the amount of money out before you’re ever able to cash any money out. That’s what happens with the liquidation preferences, so that’s why you want a really good corporate and securities lawyer that is helping you and guiding you every step of the way.

We would love to hear what you’re up to and what kind of round you’re dealing with on the comment section below. Also, Like this video, and don’t forget to subscribe to the channel so that you can follow all the new videos that we’re rolling out every week.

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