Common Features of Preferred Share Investments in Startups1

Venture capitalists and other early stage investors typically invest in startups and emerging growth companies through preferred shares (normally with associated mandatory or optional conversion provisions). Preferred shares are created in the company’s certificate of incorporation and entitle the holders to certain rights senior to those of common stockholders. The certificate of incorporation will normally include provisions authorizing the creation of preferred stock as a separate class of stock and will also authorize the number of shares of preferred stock the company will issue. In addition, the certificate of incorporation will authorize the board of directors to alter the number of preferred shares to be offered, the rights associated with such shares and the preference limitations that accompany preferred shares.

As implied by the name, preferred shares come with certain preferential rights including, but not limited to, dividend payment preferences, liquidation preferences, redemption rights, voting rights, conversion rights and preemptive rights. Venture capitalists are guided by two primary objectives when opting for preferred shares: (i) fixed income returns and a more stable value than common stock; and (ii) capital appreciation with downside protection through senior ranking in a liquidity event. Below is a quick outline of some of the key negotiating points with investors when dealing with a preferred share purchase agreement:

Dividend Payments: When preferred stock includes a dividend payment the key issue will be the dividend rate. This rate may be either fixed or variable. Normally these are listed as a fixed percentage of the “paid-in” value (the initial purchase price or liquidation value of the stock). If the company uses a floating dividend rate it gives the company the added incentive to redeem the shares as soon as possible. Dividend payments may be structured quarterly, annually or on the occurrence of a liquidity event. The parties are free to structure the dividend payments as they like and in many instances these payments come in the form of cash, additional shares or property. Note, however, that shares of stock issuable as dividend on preferred stock may need to be registered under the Securities Act of 1933, as amended, although the recent position of the Securities and Exchange Commission is that if holders have the option to receive stock dividends a company cannot register the resale of the payable-in-kind dividends until after the dividends are earned and the shares have been issued in payment of the dividends.
Liquidation Preference: This feature of the preferred stock allows the preferred shares to rank senior to common stock in the company’s involuntary dissolution, winding up or liquidation. In such an event, before any distributions can be made to common stockholders, including founders, the holders of preferred stock are entitled to receive the per share liquidation value of their preferred shares and all unpaid accumulated dividends. A key point for company’s to negotiate with investors is what constitutes a liquidation event. Stating these events plainly will dictate whether the preferred shareholders will receive a liquidation preference in a given event or if their stock will receive a different treatment.
Redemption Rights: Another feature of preferred shares is that they may be redeemable. Investors may require company’s to redeem their preferred shares at a fixed price. This feature is referred to as the mandatory redemption. If a company lacks the funds to complete a mandatory redemption on the date the shares become redeemable, the unredeemed shares must be redeemed as soon as the company is able to do so. The other feature is the optional redemption where the company has the right to redeem the shares throughout a given period of time at separate redemption prices. At the beginning of the redemption period the redemption price is set at 100% plus a premium, which declines over each year in the period that the shares are not redeemed. On the date of redemption, the company must pay to the preferred shareholder all unpaid dividends as well as the redemption price. For illustrative purposes a typical redemption rights provision is listed below:
For the first three years after issuance, optional redemption is not permitted.
Beginning on the third anniversary of the issuance date, the company is permitted to redeem the preferred stock at the following prices:
[THIRD YEAR OF PERIOD] 102.25%; and
[FOURTH YEAR] and thereafter 100%.
Voting Rights: Preferred shares grant voting rights and board representation to preferred shareholders. Often major company matters will require a majority or two thirds vote of the holders of preferred shares. Such actions include: (i) amending or repealing any provision in the company’s charter or bylaws; (ii) authorizing the creation of any new class of stock; (iii) merge or consolidate the company with any other company; or (iv) take any action that may be considered prejudicial to the preferred stockholders.
Offering preferred stock to venture capitalists and other investors also allows companies to offer their common stock to employees at a lower valuation than those of investors who purchased preferred shares. Prior to entering into agreement with your company legal counsel for your investor will draft a term sheet outlining all the terms of the deal. Term sheets, as a general rule, are nonbinding agreements except with respect to certain nondisclosure and “no shop” provisions they may include. Term sheet negotiations are often straightforward but can also take several weeks as parties haggle over the provisions and try to shift the liability pendulum on different issues. Term sheets should be as detailed as possible and offer a clear outline to all parties on how the deal will progress and it limits the potential for renegotiation down the line. While it is true that many tem sheet provisions are not legally binding it is important that you have legal input at the term sheet phase. Having your lawyer review your term sheet and even negotiate it with the your investors will assist you in getting legal terms at the early stages that are favorable to you as well as accurately reflecting the terms of the preferred shares your investors will receive.

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1 Comment


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