Why offer preferred shares to investors?
The reason for offering preferred shares to investors is that insiders (like founders and officers) have a huge amount of control over the success or failure of the company whereas outside investors have so little control.
The preferences that come with preferred shares lessen that almost intolerable level of risk. These preferences reduce risk for their owners, and generally fall into two categories. The categories are downside insurance and upside insurance.
What are “downside insurance” preferences?
Downside insurance preferences provide owners with protections in case the company does not do particularly well. Two examples are liquidation rights and anti-dilution rights.
- Liquidation rights give the preferred shareholders a multiple of their initial investment back before a general distribution of the proceeds of a liquidity event. Say the investors purchase their shares for $600,000 and they negotiate 2x liquidation rights.
A few years later, the company is acquired for $4,000,000.The preferred shareholders would receive 2x their initial investment, i.e., $1,200,000, and then the remaining $2,800,000 would be divided pro rata among all shareholders (including these same preferred shareholders).
- Anti-dilution rights give the preferred shareholders a “guaranteed best price” on their share purchase. The preference kicks in only if the company ever sells shares at a future date at a price lower than the current offering.
Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate anti-dilution rights.
A year later, the company has run into difficulties and is forced to sell shares at $1 per share in order to attract investors.
If they succeed in raising this follow-on round, they will have to issue 300,000 additional shares at no cost to the original preferred shareholders (the ones who had the anti-dilution rights); this has the effect of retroactively selling them 600,000 shares at $600,000, so they actually ended up paying the better price of $1 per share.
What are “upside insurance” preferences?
Upside insurance preferences provide owners with some additional benefits in case the company does extremely well. Two examples are registration rights and warrants.
- Registration rights allow preferred shareholders to sell their shares at the time of the initial public offering.
- Warrants allow preferred shareholders to purchase additional shares at the current price. Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate a warrant to purchase an additional 100,000 shares at $2 per share.
A year later, the company is doing poorly; the preferred shareholders will not choose to exercise their warrant.
However, if a year later, the company is doing very well, and the shares are now worth $5, the preferred shareholders may choose to exercise their warrant and purchase the additional shares
Some first time entrepreneurs avoid selling preferred shares to investors out of fear that they should not sell something “more valuable” than what they, the founders, own. However, most founders become officers and thus have almost complete control over the company’s success or demise, while outside investors have very little power to influence the success of the company.
Outside investors deserve some ability to reduce their risk and share in the upside. And the only way for them to do that is to negotiate the preferences that go with preferred shares.
ABOUT THE AUTHOR:
Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will You New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
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