Written December 1, 2016
Preferred stock is most commonly issued when a startup receives VC funding. Preferred stock provides certain economic and control rights and protections not given to the holders of common stock. Founders may also be issued preferred stock, but it's not as common and may not be advisable.
Typical economic rights of preferred stock include a liquidation preference, anti-dilution protection, and conversion rights. Control rights deal with voting issues and electing the board of directors.
Yes. Since preferred stock comes with economic and control rights and protections, common stock typically gets a lower valuation for the purposes of stock option grants or share issuances to the corporation’s employees. Employees can generally exercise their common stock options at a lower price than the price of the preferred stock. Thus, employees may feel as though they are receiving some sweat equity for their contribution to the corporation.
The usual method to create super-voting rights for a founder is to implement a dual class common stock structure, generally the “Class A” and the “Class B”. The Class A and Class B will be identical economically, but the Class A comes with 10 votes per share, whereas Class B is 1 vote per share. During formation, one or more of the founders would be issued Class A Common Stock, and everyone else such as employees, advisors, consultants would receive the Class B Common Stock.
The Benefit of the dual class structure is that the founders can maintain control of the startup as the company grows while still holding a smaller percentage of the company. As you know, founders generally put their blood, sweat, and tears into their startup and the thought of losing control doesn't seem fair; however, the dual class structure can be a potential red flag to investors.
A dual class structure has a bit of a bad reputation in Silicon Valley. It signals ego and investors avoid startups where founders are perceived as having ego problems. I usually advise my clients not to implement a dual class structure unless they are a very “hot” startup or have a good track record with investors. If you've already implemented dual stock, don't worry, it can be amended.
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