Shares are bundles of rights, mainly voting in the shareholders meetings and participation in dividends and exits. With respect to startups, there are two major types of shares: ordinary shares, which are usually granted to the company’s founders and employees, and preferred shares, which are usually issues to investors.
Preferred shares typically have two extra economic rights in relation to ordinary shares:
First, in case of an exit, the preferred shareholders shall receive, before the ordinary shareholders, their investment amount, usually with the addition of interests (liquidation preference). Sometimes, investors even require receipt, before the ordinary shares, an amount which is the product of multiplying their investment amount by a certain number. Under the classic structure, the preferred shareholders shall be entitled to get, after receipt of the investment amount (and the additional thereto), also their share of the remainder of the exit consideration (participating preferred shares).
This situation results in the exit share of the preferred shareholders being larger than their holdings in the company, thus more extensively diluting the ordinary shareholders (such as founders and employees). The smaller the exit, the greater the impact of the preferrence therein. While investors strive to protect themselves as much as possible, this structure significantly impairs the incentives of founders and employees.
Second, in case of a later investment round at a price lower than the price per preferred share (down round), the preferred shares are protected against dilution. In the past, it was customary that such protection is absolute, i.e. the lower price shall be implemented retroactively on the preferred shareholders and their number of shares shall be increased accordingly (full ratchet). During a startup’s life, it may, in many cases, need investments at relatively low prices. An extreme anti-dilution protection may practically dilute the other shareholders and deter future investors.
There are two customary ways to mitigate the exit preference. One is to agree that if the amount the preferred shareholders would get should they be ordinary shareholders is more than an amount which is the product of multiplying the investment amount by a certain number, then the preference shall no apply. The second is to agree that the preferred shareholders shall be entitled to the greater of the amount they would receive in preference (without participating with the ordinary shares in the exit distribution) and the amount they would receive if they were ordinary shareholders (non-participating preference).
Regarding the anti-dilution protection, there are several customary paths to mitigate it. First, it can be limited by time. Further, currently anti-dilution mechanisms that are based on a weighted average of all of the company’s issued shares (narrow based weighted average anti-dilution) or all shares in broader sense, including, for instance, the shares reserved for equity incentive plans (narrow based weighted average anti-dilution), are frequently used.
Another path is to persuade the investor to do with ordinary shares. That may be possible mainly in the earliest stages of the startup. In many cases the investor in such stages are friends and family and you can explain that issuing preferred shares at such an early stage will result in a complex share capital that may be detrimental to the company in the future. In addition, this is possible with strategic investors, the main interest of which is not financial (their exit status is less critical to them). In the past, I managed to convince a large strategic investor in a startup that already had issued preferred shares to be issued ordinary shares, subject to the conversion of the existing preferred shares into ordinary shares.
In summary, from the startups side, it is evident that the time of initial preferred shares issuance should be deferred as much as possible. However, when the time comes, there are solutions to the challenges preferred shares raise, that you must implement.
News1 published a Hebrew version of this post at http://www.news1.co.il/Archive/003-D-130856-00.html