It is important for California Startup Company owners to understand the differences between preferred stock and common stock. Liquidation preferences and dividend obligations can place unbearable financial burdens upon a company that is unprepared to meet them. By understanding the rights and obligations that a corporation incurs by issuing either common stock or preferred stock, business owners can determine which type of stock to issue and how much in order to best serve their startup’s needs.
In general, preferred stockholders have priority in: (1) the distribution of dividends, and (2) the liquidation of company assets during times of insolvency. Because of these lucrative preferences, preferred stock typically commands a higher price for purchase than does common stock. Of course, the added financial obligations can burden a company that is unprepared to meet them, and it can also further devalue common stock if common stockholders are not consistently paid adequate dividends. It is therefore important that businesses not issue more preferred stock than they are financially able to bear.
Other Complications of Preferred Stock
Other characteristics of preferred stock can also make it more financially burdensome for a company to issue. For example, redeemable preferred stock contains a “call option”, which allows the stockholder to force the company to redeem the stock and pay a set rate for it. This option typically vests after a set date of maturity. Because the option of redemption is at the stockholder’s preference, it favors the holder, and redeemable stock can thus command a higher price as a result. But this, too, is an option that can place an unanticipated financial burden on a company because the startup does not have the legal right to determine when the redemption occurs. It must be prepared to pay out redeemed stock upon the demand of stockholders.
Many types of preferred stock are also issued with the option to be later converted into common stock. However, increasing the amount of common stock dilutes the value of common stock, which can affect investors and business owners alike. Thus, if a business does not have the ability to control the timing of preferred stock conversion, the dilution of common stock can adversely affect the overall value of the corporation. It is important to plan for this contingency and issue preferred stock and common stock in ratios that promote continued investment and sustainable growth.
Preferred stock can also be issued with voting rights that are greater than, less than, or equal to the voting rights of common stock. Greater voting rights assigned to preferred stock gives preferred stockholders more control of the business than common stockholders, so stockholders will often pay a premium for this right. Therefore, for various reasons, it is important to balance the interests of higher stock prices versus potential loss of control over the business when determining the number of votes to assign to preferred stock.
Experienced Legal Advice for Your Startup’s Legal Needs
The skilled startup attorneys at Startup Company Counsel will ensure that your stock transactions are written and executed appropriately in order to protect your startup’s legal and financial interests. Call (408) 441-7555 or email admin@startupcompanycounsel.com to schedule your consultation with an experienced Silicon Valley startup attorney.
