editione1.0.1Updated September 19, 2022
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founderEntrepreneurs have a mixed perspective on preferred stock, depending on the particulars of the preferences. On the plus side, raising a preferred stock round means they are raising a significant amount of money, and that is likely what they need to keep going and growing.
The downsides for the entrepreneur are:
The benefits of the preferences that accrue to investors in a preferred stock round come generally at the expense of the entrepreneur and the pre-existing stockholders. Convertible note and convertible equity holders usually convert into the same class of stock (the preferred) that is creating the qualified financing and triggering the conversion. (The most common exception to this is when the convertible debt or equity is converted into a subclass of the preferred stock to avoid the problem of the liquidation overhang.)
Negotiating the preferences and pricing can consume a lot of legal resources, especially if they are unfamiliar with the terms. (If you’re a founder raising your first angel round, we suggest reading the Holloway Guide to Raising Venture Capital, which dives deep on term sheets from the entrepreneur’s perspective.)
In addition, one of the typical terms of a preferred stock round is a requirement that the company pay the reasonable attorneys’ fees of the investors.
What can often feel the most onerous to entrepreneurs are the liquidation preferences, especially if these stack up across multiple rounds. As we will explain below, it can mean that in an acquisition scenario that is not a home run, the investors might double their money, while the entrepreneur is left with little.
Investors like preferred stock rounds for a number of reasons:
The price is set and the investor knows what percentage of the company they own.
If an investor has participated in non-priced rounds like convertible debt or convertible equity, they will finally know what they have bought for their money. This is the case as long as the preferred stock round is a qualified financing that converts the convertible notes into stock shares and any convertible equity into actual stock shares on the cap table.