Preferred Stock
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
Preferred stock comes in various shapes and sizes, depending on the intent and desires of the planners. Assuming it is so authorized in the charter, the board of directors may fix the rights, preferences, and privileges of the preferred, a practice creating what is known as "blank-check preferred." There are virtually no limits on the board's authority to frame a mosaic of rights and call the same a "preferred" stock. Some of the reasons to prefer (pardon the pun) preferred stock as a financing device have been discussed elsewhere in the text—that is, the "eat-'em-up" preferred, which makes possible price differentials between prices paid for stock by the investors and the founders. An overriding reason is convenience: although it is possible to work with other devices, it is particularly handy to use preferred stock as a mechanism to adjust the relationship between the cash and non-cash investors; that is, to create specific rights in the cash investors such as special voting rights, anti-dilution protections, control shifts, "supermajority" veto provisions, and the like. A preferred stock can either be voting, nonvoting, or voting only upon certain issues, or upon the happening of certain events. In the case of the convertible preferred customarily issued in a venture financing, it is the norm to provide that the preferred votes pari passu with the common as if it has been converted. The traditional notion of preferred stock encompasses a share that takes its "par" value in liquidation before the common gets anything (a meaningful privilege if the company is being sold) and has a preferred call on the earnings of the corporation during its life in the form of a regular dividend. A "preferred" dividend implies a fixed dividend payable at regular intervals; if the dividend is not declared for any reason (perhaps illegality, if and to the extent sufficient earnings or surplus are not available), it can "cumulates," meaning arrearages must be paid in the future before any dividend or liquidating distribution can be paid on inferior classes of stock, such as common. (Unlike interest, cumulative dividends are usually not augmented by an incremental additional payment keyed to the period during which they remain unpaid—interest on interest.) Cumulative dividends dilute the common shareholders as they accrue. Assume the venture capitalist owns 50% of the Company (as converted) and the cumulative dividend is 10%. The common is diluted 5% per year.
Cumulative dividends expressed in cash terms are not common in start-ups. The idea of paying cash dividends at all makes no sense to some entrepreneurs (e.g., Kenneth Olson while at Digital Equipment), because the transaction is ultimately dilutive if and as the issuer, in effect, retrieves the capital paid out in dividends by issuing more stock. More importantly, immature companies often do not have the cash with which to pay dividends. Noncumulative dividends, meaning dividends paid only if, as, and when declared by the board, are a venture-capital norm. See Encyclopedia Book 21 for the latest information on whether the "market" is cumulative dividends versus dividends only when declared … never. Indeed, the disclosure document in a preferred-stock venture financing often contains a caveat to the effect that the dividends are not only noncumulative; it is "unlikely" the directors will declare them at all. Automatic conversion on the eve of an IPO is routine. It is necessary to clean up the balance sheet and cancel various special rights peculiar to separate classes of stock if an IPO is to occur at all the liquidation preference is the cost basis for the number of common shares into which the preferred converts, meaning it is the number which is divided by the conversion price yield the numbers of the conversion shares.