What is preferred stock and why it is issued to the investors?

While startup founders, employees and other business participants have common stock in a corporate entity, investors usually demand preferred stock. Preferred stock is a stock generally superior to the common stock because there are a number of preferences associated with it. Preferred stock was created to give companies the opportunity to raise funds while affording certain protections to the investors.

 

When we talk about preferred stock in the publicly traded corporation, its owners usually enjoy priority in dividend distribution, liquidation proceeds; maybe have some voting preferences and board representation of the class. The situation is quite different when we refer to the preferred stock in a startup entity. Investors usually don’t expect a startup with limited or no operational history to pay dividends. The preferences they negotiate normally exist to protect their investments. Those would be board representation and voting or veto power on the matters that are vital for the investment, liquidation preference in case the company has to liquidate either voluntarily or non-voluntarily, anti-dilution protection, redemption right, right of first refusal and similar. Dividend preference may be included as well, but usually dividends are cumulative, which means they are not paid regularly, but accumulate on paper and distributed once the company hits certain event (e.g. sale, merger, IPO).

 

There are two main arguments for granting preferred stock to the investors and not the common equity. First, it allows granting common stock to the founders and employees at a nominal price. Higher value of the preferred stock may be attributed to the preferences its holders enjoy. Otherwise, the law requires all stock to be sold at the market value and if a portion of the equity is sold at a discounted price, both the sellers and the buyers may be harshly penalized.  Second, the argument goes that people who invest hard cash in the beginning of the business development should enjoy higher benefits for the risks they’re taking and in any case the development of the business may not happen or be significantly postponed without their help. This is how the so-called industry standard was formed.

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