stock, restricted-stockI recently saw a quote that many legendary entrepreneurs say the most important lesson they ever learned was what preferred stock is and how it affects their startups. My question is: What is preferred stock, how is it different from common stock, and why would entrepreneurs think it’s so important for startups?
(I see there is a tag for restricted-stock–is that another term for the same thing?)
Ultimately, it comes down to how preferred shares vs common (or otherwise named) shares are defined within any corporate documents. As an example, preferred shares can be defined such that dividends and other arranged monies they are paid out FIRST and on a different basis vs say Class B which may be paid out on what could ultimately end up being crumbs (what’s left over after the big players have taken their piece).
Preferred shares can also be considered ‘voting shares’, while others are ‘non voting’. Sometimes, preferred shares can also be associated with some form of debt ownership which also gets paid (e.g. my preferred shares mean I own some largish X% of the company, but I also lent you some money you needed in order for the share exchange to happen, and you also owe me interest/repayment according to a predefined agreement that you must also pay out to me). So in the end it varies. These details are typically included in shareholder agreements and/or articles of incorporation.
Question 1 and 2:
So why is it important for founders?
First thing is understanding a very basic correlation within the financial sector: More Risks <-> Higher Price <-> Higher Earnings
... or the more risk you are willing to take the more profit is for you.
Founding a company has high risks, which is somehow distributed within the founding team. Not sure, if there is a usecase to distribute preferred shares to a team member, but maybe someone can add something here.
So "Preferred Stocks" (PS) is a huge topic, when talking with investors. There is a risk of loosing a lot of money, when give PS away.
The investor only have little influence on your business and are not allowed to interfere, EVEN IF YOU DO SOMETHING, THEY DONT LIKE. Of course they will still try to influence you and most founders dont keep them at bay. BUT on the other hand, they are able to increase their assats and reduce their liabilities. If not understood well, PS could be a bad deal for founders.
To get a good deal, you have to convince your investor, that you will do no "moral hazard" against him. This can either be done, by restricting your scope of action or by implementing some over watch mechanisms so your investor has the possibly to act.
Hope this answers our question. If not, feel free to ask.
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