There is a class of founder preferred stock (called “FF preferred”) that solves a huge problem for the right cases and that is the problem of how in the world can founders sell a portion of their shares in interim funding rounds without causing all sort of problems.
Here is why: you have a fabulous success as a venture and you do your Series A round at $50M pre-money valuation. The VCs are investing $15M and are more than happy to incentivize the founders by letting them cash out $3M worth of their shares to help them spread the risk (i.e., take the $3M now as walking-around money and then stay with us as we shoot the moon in putting everything else at risk). But how do they do this? In this sort of case, the founders hold common stock.
Therefore, the VCs don’t want to buy any stock directly from the founders. That would leave the VCs holding common stock as opposed to the preferred stock that is being sold in the round. So the only available method is to have the VCs buy $15M in preferred stock, to put all that money into the company, and to then have the company (with the VCs consent) buy back common stock from the founders at preferred stock pricing. All a dream case for the founders, right?
In fact, this scenario has lots of problems. First, it has the company paying for common stock at preferred stock pricing. Usually, after a Series A round of this type, the price of the preferred is set at what the parties negotiated for the round. But the price of the common is only set after the round based on a 409A valuation done by an outside firm. And almost invariably, the common stock price is set at no more than 25 to 33% of the preferred price. There are several reasons for this. First, it is right that the preferred stock be valued higher because the preferences attached to the stock do in fact have real value. This is recognized by all concerned, including the tax authorities.
Second, startup ventures want to be able to grant stock options and other equity incentives at relatively lower prices so that such incentives will be seen as advantageous by key people wanting to join the venture. Therefore, you need to have a significant differential between the respective preferred and common stock prices. So what happens if the board approves having the company redeem common stock shares from founders at preferred stock prices?
This is at best a huge anomaly. In a worst case, it also means that the common stock price would be set arbitrarily high and bear little or no discount from the preferred stock price. At a minimum, you would need to convince a 409A firm to treat the deal as a one-off situation that shouldn’t affect common stock pricing generally. Even worse, the very likely outcome of this scenario is that the dollars paid to the founders to redeem their stock will be treated as ordinary income to the founders – basically, as some sort of bonus compensation for their services – as opposed to being treated as a sum paid for their shares that the founders can treat as a capital gain.
There are many nuances to these sorts of scenarios but basically, if all the founders are holding is common stock, the options for cashing out part of their holdings in a funding round are few and not that good.
This is where the FF preferred stock can solve a lot of problems. With this class of preferred, you might have, say, 10M authorized shares of which 9.4M are common and .6M are FF preferred. The founding team takes 6M shares in total at inception, 5.4M of which are common shares and .6M (10%) are FF preferred. They pay the same $0.0001/sh (or whatever other nominal price) for the common and the FF preferred when they buy their shares. The common shares are typically subject to vesting but not so with the FF preferred because these are treated as an investment and not an earn-out.
The terms of the FF preferred provide as follows: this is a class of preferred stock that can be sold to investors in a preferred stock round so long as the investors agree; if the investors do not agree, then the stock sits there and, in the end, is treated the same as preferred stock; the FF preferred can be sold but it then becomes like common stock in the hands of another party; if, however, it is held by the original recipient, and if the investors agree in a round to buy it from that person, then, upon such purchase, such stock transforms in the hands of the buyer into shares of preferred stock of the type being sold in the round (that is, if FF is told to a VC in a B round, the buying VC winds up holding B shares after the FF shares convert into B shares in its hands).
Hence, in buying FF preferred, the VC gets the preferred stock it wants to buy; the founder gets paid for the FF preferred being sold at the price prevailing for the preferred stock being sold in the round; the founder reports the transaction as a sale of preferred stock and claims capital gains treatment on the sale; all the while, no form of common stock is sold and hence there is nothing in the deal to mess up the common stock pricing for option issuance purposes.
For the right cases, FF preferred is a valuable tool. Again, it is probably best deployed by strong founding teams because VCs can easily say no if they don’t have the right comfort level.
As with super-voting stock, this class of stock is a good one to consider for any team that believes it will have significant leverage with investors when it comes to financing rounds. Again, as with super-voting stock, it can easily be taken out of the mix if investors should insist that it be removed. Therefore, it is a usually a pretty good idea to consider adding it for positioning at inception if you believe you will have the potential negotiating leverage to use it.