Preferred Stock
Best Practice Summary

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Equity securities of any issuer, whether a corporation, partnership or limited liability company ("LLC"), may be divided into more than one class or series, with each class holding a defined set of rights as negotiated among the issuer and the various investors. LLCs will define classes and series of ownership in its operating agreement, and partnerships will do the same, if desired, in a partnership agreement. While all three types of entity are able to create different classes of equity ownership, corporations are more heavily regulated in this respect under applicable state law than limited partnerships and LLCs.

State law generally provides that common stock is the class of stock that is last to receive assets of the corporation in the event of its liquidation. In general, preferred stock is any stock whose holders have a special right to receive distributions of assets of the corporation ahead of holders of common stock. There may be more than one class of preferred stock (as well as more than one class of common stock).

Preferred stock is structured to attract investors and accordingly may have a number of other special rights in addition to its priority in the event of a liquidating distribution. Most preferred stockholders are angel investors, venture capitalists or other accredited investors. Separate classes and/or series are created to fit particular investor needs and/or to effect separate financings over time at different prices. While public companies may issue preferred stock, it is most often seen in the financing of private companies.

Note: The issuance of preferred stock of any class or series automatically terminates a company's status as a "subchapter S corporation" with the IRS because an S corporation may issue only one class of stock.

Authorized Stock

Preferred stock, like common stock, must be authorized in the charter of the corporation before it can be issued. If an insufficient number of shares are currently authorized to permit the sale of the full number of preferred shares expected to be sold, the authorized stock of the corporation must be increased. Unless "blank check" preferred stock is used, the special rights and preferences of preferred stock must be stated in the charter when the preferred stock is created.

Blank Check Preferred

"Blank check" preferred stock, available in some states, permits the company to authorize a class of preferred stock via a stockholder resolution, but leaves the definition, designations, rights and preferences of the class to be fixed later by the board of directors rather than immediately. The advantage of blank check preferred stock is that once it has been authorized, a stockholder resolution is not needed at the time the company finishes negotiating the terms of the preferred stock and is ready to close a financing.

Rights and Preferences of Preferred Stock

What follows is a discussion of various common rights and preferences of preferred stock.

Liquidation Preference
A liquidation preference is the fundamental characteristic common to all preferred stock. Upon a sale or liquidation of the company, holders of preferred stock are entitled to receive a fixed amount of the proceeds of the sale or liquidation prior to any payments to holders of common stock. The most common form of liquidation preference gives the preferred stockholders the right to receive back the amount invested before any proceeds from the sale or liquidation may be paid to common stockholders.

Many variations are possible. Some liquidation preferences give the preferred stockholders the right to receive accrued dividends in addition to the cost of the preferred stock. Participating preferred stock allows the preferred holders to share the remaining proceeds with the common stockholders as if they had converted to common, but after the company has paid the preferred holders their liquidation preference. In extremely high-risk investments, the preferred holders may receive the right to receive a fixed amount in excess of their cost (sometimes two or three times their cost) before any payments are made to common stockholders. The tax consequences of such a "multiple liquidation preference" should be examined before such a provision is agreed to.

Voting Rights
Preferred shares may or may not have voting rights in addition to the basic rights provided by state law. For non-convertible preferred, it is not uncommon for preferred stockholders to have no voting rights unless dividend payments or redemption does not occur when due or some other adverse event occurs. On the other hand, preferred stock that is convertible to common stock generally may vote as if the shares had been converted into common.

Anti-Dilution
Both convertible and non-convertible preferred stock often have special voting rights, particularly the right to elect a certain number of directors of the company and the right to veto certain significant corporate activities.

In a convertible preferred stock financing, the investors will generally be able to negotiate “anti-dilution protection” to protect themselves from future issuance of stock at lower valuations than the valuation used in their original investment. The two most common forms of anti-dilution protection are called “full ratchet” and “weighted average”.

"Full ratchet" protection is the more severe form of anti-dilution protection. It provides that if the corporation issues any stock in the future at a price lower than that paid by the investors (with certain negotiated exceptions), the investors will receive a change in the conversion price of their preferred stock so that they will be treated as having paid the same price as the new investors.

“Weighted average” protection adjusts the conversion price of the investors’ preferred stock by a lesser amount, depending on the amount of lower-priced securities being issued in the new financing.

Anti-dilution language generally appears in the terms of preferred stock set forth in the company's charter. Anti-dilution protection is occasionally (but rarely) also provided to recipients of common stock warrants via contract.

Sample Anti-Dilution Language

"The conversion price of the [Series __] Preferred Stock will be subject to a [full ratchet] [weighted rachet] adjustment to reduce dilution in the event that the Company issues additional equity securities (other than shares (i) reserved as employee shares described under the Company’s option pool, (ii) shares issued for consideration other than cash pursuant to a merger, consolidation, acquisition, or similar business combination approved by the Board; (iii) shares issued pursuant to any equipment loan or leasing arrangement, real property leasing arrangement or debt financing from a bank or similar financial institution approved by the Board; and (iv) shares with respect to which the holders of a majority of the outstanding Series A Preferred waive their anti-dilution rights) at a purchase price less than the applicable conversion price. In the event of an issuance of stock involving tranches or other multiple closings, the antidilution adjustment shall be calculated as if all stock was issued at the first closing. The conversion price will also be subject to proportional adjustment for stock splits, stock dividends, combinations, recapitalizations and the like."

Dividends

Preferred stockholders often receive an enhanced right to receive dividends. Common types of dividend preferences include:

Accruing Dividends
Accruing dividends are scheduled payments in cash or stock made to stockholders based on a formula, which represent an obligation of the issuer whether or not the board of directors subsequently declares a dividend. If the payments are not made in accordance with the schedule, the dividends accumulate until paid. Thus they are often referred to as "cumulative dividends". The most common form of cumulative dividends gives the stockholder the right to receive a fixed percentage of the cost of each share per year, as if it were interest on a loan. Cumulative dividend provisions usually provide that if directors declare a dividend, preferred stockholders must be paid all outstanding accrued dividends before any dividends are paid to common stockholders. In many cases, the issuer is not required to make any payments of accruing dividends until some kind of "liquidation event" occurs: a liquidation, redemption or sale of the company. If convertible preferred stock is converted to common stock, it is a matter of negotiation whether accrued dividends are paid or lost.

Dividend Preference
A dividend preference, unlike the right to accruing dividends, does not give stockholders the right to receive any particular amount of dividends, but simply states that if dividends are declared, preferred stockholders must receive a stated amount of dividends before any dividends are paid to common stockholders.

Conversion Rights

Convertible preferred stock grants the holder the right to convert shares of preferred stock held into another class, usually common stock, at a specified rate. Conversion rights grant the holder the advantages of both equity and debt financing. The holders of convertible preferred stock retain priority on liquidation in addition to all the special rights accruing to preferred stock, while retaining the option to convert to common stock if the company's value increases, thereby enabling them to share in the value of the increase. Conversion rights are provided in the charter or, less commonly, in a stockholders' agreement. Sufficient shares of common stock to effect the conversion of all convertible preferred stock should be authorized in the charter at the time the convertible preferred stock is authorized (although this may not be possible in cases where the conversion rate may vary).

Redemption Rights

Preferred stock investors in private companies are often concerned about achieving liquidity -- the ability to sell their shares -- in the event that the company does not go public and is not sold within a specified period of time. A redemption right grants the investors the right to sell their shares back to the company for a fixed price at a fixed time. The fixed price is generally the cost of the stock, but, as with liquidation preferences, many variations are possible. Since most emerging companies will be unable to raise the cash to repay preferred stock investors unless a liquidation event occurs, a redemption provision may include procedures for installment payments, the creation of a "sinking fund", or for investors to take control of the company if the payments are not made on time.

Some redemption features give the company a benefit by requiring redemption on a certain date, so that preferred stock investors must convert into common stock if they wish to continue their investment.

Legends

Stock restrictions must be noted on the reverse side of stock certificate pursuant to Article 8 of the Uniform Commercial Code. Notices on the back of stock certificates are known as "legends". In addition to the Securities Act legend that appears on the back of all certificates for stock of a privately-held corporation, preferred stock certificates may be required to bear a legend stating that the issuer is authorized to issue more than one class of stock and a legend referring the reader to the issuer's charter for a description of the rights and preferences of the preferred stock.

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