This post discusses whether founders should authorize preferred shares, in addition to common shares, when they incorporate.
As I discussed in What is Preferred Stock?, corporations typically issue preferred shares to institutional investors, such as venture capitalists (VCs). The term “preferred” refers to preferences that those shares have relative to common shares.
For example, these preferences might include:
- A prior claim on earnings, assets and dividends
- Convertibility to common stock (to take advantage of the corporationâ€™s increased value)
- Superior voting rights
- A veto over certain types of corporate transactions
- Election of a specified number of directors on the corporationâ€™s board
- The right to have the corporation redeem (repurchase) shares under certain circumstances
On two occasions, recently, founders told me that they intend to seek VC funding. They assumed this meant they should authorize preferred stock when they incorporate.
No Preferred Shares at Incorporation
I said “Wrong!” Here is what I explained to them:
- The investor and the existing stockholders negotiate specific preferences at the time the investment is made.
- There is no way to predict, at the time of incorporation, the correct number of preferred shares or appropriate preferences.
- Furthermore, when a preferred investment is made, the investor will draft a new charter document, bylaws, etc.
- So, there is no reason to authorize preferred shares up-front, when you incorporate.
In summary, there is no need to think about preferred stock when you form your corporation. If you are fortunate enough to receive a VC investment, you will have ample opportunity to discuss preferences, and amend your certificate or articles of incorporation, at that time.
Image credit: The Balance