After an entrepreneur has used her initial “seed” money to start her business and begin operations, she may find that seeking out an additional capital infusion is necessary or desired to continue her company’s growth. While there are many avenues through which additional monetary resources can be sought, this article will focus on the means briefly discussed already in Part I, namely preferred shares of stock.
Preferred stock is a class of shares that by definition entitle their holders to priority payment on dividends and their asset value in the event of liquidation over holders of common stock. Preferred stock typically give investors a fixed, prioritized return, but they do not necessarily come with voting rights or a proportional share in the value of a company when it is sold. However, the specific attributes of the preferred shares that a company sells are variable, and a major aspect of negotiations with investors is designing the shares in a way that meets the needs of both parties.
This article will discuss three of the most important negotiable attributes of preferred stock: liquidation preferences, conversion rights, and voting rights. The article will also briefly discuss the federal and state registration requirements entrepreneurs must follow when executing such transactions.
Non-participating preferred stock entitles its holders upon liquidation of the company to the return of their investment plus any accrued dividends prior to the distribution of any proceeds of the sale to the holders of common stock. A liquidation event typically refers to the sale of the company.
Participating preferred stock entitles its holders to the same returns as are granted by non-participating preferred stock as well as their proportional share in the remaining proceeds of a liquidation event.
Clearly then participating preferred stocks are more desired by investors whereas non-participating preferred stocks are preferred by companies, making this designation a key point of negotiations. While the financial needs, valuation, and potential return on investment of a company will in great part dictate whether preferred shares sold to a particular investor are participating or not, companies can offer a higher dividend rate or a liquidation multiplier as an alternative to proportionate participation in the proceeds of a sale.
Offering to pay a higher dividend to an investor is enticing in that it presents a fixed, prioritized return that is of greater value than a dividend paid on common stock. This scenario may be enough to sway negotiations in the entrepreneur’s favor, but if it is not, she may also offer a higher liquidation multiplier to the investor.
While preferred stock entitles its holder to the return of her entire investment upon liquidation, this value may be augmented by a multiplier that is negotiated by the parties. A multiplier also gives the investor a fixed return that is prioritized over common shareholders, which in turn gives the entrepreneur an additional negotiating tool to avoid issuing participating shares of stock.
A related but distinct, variable attribute of preferred stock is whether or not the holder of the stock has the right to convert her shares to common stock, i.e. has conversion rights. If the holder of preferred stock has conversion rights but the shares are non-participating, she has the choice between receiving her fixed liquidation preference or giving it up and converting her shares to common stock and thereby receiving her proportional share in the proceeds of a liquidation event. The following example illustrates when each choice would be more beneficial to an investor:
An investor purchases a 10 percent interest in a company for $100,000 in the form of non-participating preferred stock. The price is $1 per share, granting the investor 100,000 shares of non-participating preferred stock. The remaining 900,000 shares are all common stock.
If the company is later sold for only $900,000, the value of the common stock would go down, but since the preferred stock price is fixed, the investor would still receive $100,000 first and the remaining $800,000 would be distributed the common stockholders. Under this scenario, had the investor chosen to convert her shares to common stock, there would be $900,000 to divide over 1 million shares of common stock, resulting in a price of $0.90 per share and just $90,000 to the investor.
Alternatively, if the company sells for $2,000,000, the value of the common stock would significantly increase. If the investor does not convert, she would still receive her $100,000 first, but if she were to convert, her 10% stake would be worth $200,000, so clearly she would exercise her conversion rights here.
Conversion rights are another great negotiation tool for entrepreneurs and can create a mutually-agreeable middle ground where the company will not have to issue participating shares and allow an investor to “double dip,” and an investor gets the benefit of choosing between the greater of two potential outcomes, the worst of which is her prioritized, fixed return.
Preferred stock does not typically come with voting rights because it is generally offered to investors to whom the company does not want to extend any control over its operations; the arrangement is strictly financial. However, circumstances may warrant that an entrepreneur offer preferred stock that comes with either full or limited voting rights. By presenting the investor with the opportunity to have a voice in the operations in the company and potentially even representation on the board of directors, the entrepreneur may be able to receive more favorable financial terms from the investor or to persuade a desired investor who otherwise might not be interested.
Entrepreneurs should take note that while they may not explicitly offer preferred shareholders any voting rights, some states expressly provide that all shareholders, including preferred shareholders, possess particular minimum voting rights and be permitted to vote on certain matters.
One of the main differences between this round of investing and the initial, seed round is that at this point the entrepreneur is most likely going to be working with experienced, savvy investors rather than friends and family. Because of the obvious, practical differences between the two types of investors, the law imposes different requirements for transactions with each classification.
The professional or experienced investor to whom the entrepreneur should seek to sell preferred stock is defined as an accredited investor, which we defined in Part I of this series. An entrepreneur may file for registration exemption with the Securities and Exchange Commission (SEC) much like she did during the friends and family round under Regulation D, but instead of applying under rule 504, the entrepreneur should use rule 506. Rule 506 allows an investor to raise an unlimited amount of money provide she meets one of two exceptions.
The first exception falls under rule 506(b), where the company: (1) Must not solicit generally or advertise the securities; (2) May sell securities to an unlimited number of accredited investors and up to 35 non-accredited purchasers who demonstrate they possess a certain level of knowledge and experience to be able to asses the risks and rewards of the investment; (3) Must give non-accredited investors the same information they give to accredited investors; (4) Must be able available to answer prospective buyer’s questions; and (5) Provide certain financial statements certified by an independent public accountant.
The second exception falls under rule 506(c), which allows the company to broadly solicit and generally advertise the offering but still be deemed to be undertaking a private offering if it (1) Only offers to accredited investors; and (2) Takes reasonable steps to verify the investors are accredited.
While one of the advantages of Rule 506 exemptions is that it pre-empts state registration and qualification requirements for offerings, it does not pre-empt state laws with respect to registering as a broker-dealer, so entrepreneurs should not assume that a 506 exemption precludes them from needing to take action on a state level.
Entrepreneurs who reach this phase of investment have generally already navigated the financial, legal, and other obstacles they faced in setting up their company and beginning operations, and they should exercise the same diligence and effort in negotiating and transacting with accredited investors. Having an understanding of the various negotiation tools and potential arrangements with investors gives entrepreneurs vital knowledge and leverage for reaching financial terms that are of a maximum benefit to their companies.
As with any major financial transaction, entrepreneurs are encouraged to consult with an attorney before taking any official action, as each state has its own particular requirements that must be followed, and entrepreneurs should be confident that they are in good standing on both a state and federal level. The above article is not intended to be legal advice or a complete procedural manual for accepting capital from accredited investors. Additionally, every business has its unique requirements and speaking with an attorney is the best way to know that the needs of your business are being met in compliance with the law.
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