angel-investors, seedI am setting up a company with a few friends but we would like to rope in an investor. We have subscribed some ordinary shares which we can obviously afford to pay for. Now we need some extra money and we thought we can convert our ordinary shares to preference/redeemable shares and offer them to the investor at a higher price. Is this a legal /accepted method that other startups use out there? If this is not allowed (converting ordinary to preference) what other way can I approach this?
Your question is really very region-dependent, as there might be huge differences between different juridictions. Even in one only country (the US for example) each different State will have a different view on that matter. You have not told us what is your incorporation/creation region, so answers can only be generic.
Preferred Stock
In most jurisdictions I know, you are free to issue different classes of shares (given that you have a company that is divided in shares, would it be a Delaware Corporation, an Uruguayan or Panamenian or Brazilian SA, etc.) Common shares, as the name states, are the ones that most of the regulations and rights and obligations are made for. You can also, again depending on your laws, issue preferred shares, that can usually have many different “classes” within. Within each class of the preferred shares you can specify different rights or obligations that are specific to that stock type. So like it is usual in Brazil (my country), preferred shares here commonly have no voting rights in the assemblies, and, as such, cannot exercise any kind of control. But they have priority in dividend distribution and usually have a higher dividend rate than common shares.
The idea of having preferred stock issued to investors is that you give them some special rights within their class of shares. I have seen preferred shareholders have the sole ability to chose the CFO of a company, for example, so even if they only hold the minority of votes, they can still exercise a lot of power in what it is important to them.
Converting Common into Preferred Stock
It is usually possible to convert common shares into preferred shares (again, depending on your local laws!), as long as you manage to have 100% approval of all shareholders in a corporate assembly. And that is also true for the creation of the preferred class, which has to be done before converting the shares.
Issue of New Preferred Stock
But, that is not really what I think you want. If that common shares have already been issued, and are currently owned by you (the founders), if you convert them into preferred and sell them to investors, then the money would go into your pockets, not into the company. Because you already own the shares, so you are selling something that already belongs to you. No serious investor will put money into your pockets instead of into the company in an early stage company, which is always hungry for resources. This is called a cash out, as you are really selling part of your ownership in the company.
The thing I suppose you want to do is issue new shares so that the investors will buy newly issued stock from the company and as such the money they put in will land as capital for the company, not money in your pockets.
The first thing you need to do, again, is to approve the creation of this preferred stock class, then define the special rights of that preferred stock class, then you have to issue the stock to the investors directly, and they will put the money in the company’s bank accounts. But that process is usually only started after the negotiation with the investor is in advanced stages, because many of the rights they demand will be subject to the negotiation between you two. What you need to be ready for is to create this class and accept that investors will demand some rights that common stock will not have.
Higher Value of Issued Stock
If you want to sell the share you already own, you can just charge any value the other side is willing to pay, as this is your property and in free countries you usually have no regulations on what you can sell anything you own for.
When you issue new shares, you usually can issue them at whatever value you wish. In some jurisdictions, Brazil for example, you need to account the emission in two different accounts. One of them is the “Capital” account, which is the account that holds the “property” information so the value contributed by each shareholder to this account is what really represents the “owned fraction” of the company. And the remaining of the value goes into another account called “Goodwill premium in share emissions”, that does not count towards property/ownership representation.
For example if you already have $100,000 in 1,000 shares outstanding, previously issued and paid for, so you have $100,000 in the Capital account. Each share was issued at $100. Now you want to issue new shares at $200/each, because your company is in another phase and valuation is higher. For each new share costing $200, $100 will be added to the “Capital” account and the other $100 goes into the “Goodwill premium in share emissions” account. That Goodwill account will hold the difference between your lowest priced share (the first ones you issue usually) and the prices charged for every other share you issue.
This is what is required to issued shares at any value in Brazil. Each jurisdiction will have its own rules. A local accountant will surely know how to do that in your jurisdiction.
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