by Cliff Ennico
Cliff Ennico
(www.succeedinginyourbusiness.com), a leading expert on small business law and
taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax
and Legal Answer Book” and 15 other books.
“My two partners and I formed a
corporation to run a Web-based business.
The business has taken off, and we are being approached by some local
angel investors.
We are delighted,
of course. The problem is that these
investors all want preferred stock, and our corporation is not set up for
that. How can we do this, do we need an
attorney, and how much will this cost?”
When a
corporation first starts up, its owners receive common stock – a percentage
interest in the company’s assets and liabilities. If the company goes under, holders of common
shares split the proceeds of liquidation based on their percentage ownership of
the company after all debts have been paid.
If a company
issues preferred stock, however, the rules change. While preferred stockholders have a
percentage interest in the company just like common stockholders do, if the
company goes under, holders of preferred stock are guaranteed to get their
investment back before the common stockholders get anything (this is called a
“liquidation preference”).
Think of
preferred stock as a “hybrid” of debt and common stock. Like debt, it gets repaid if the company
liquidates or goes out of business, sometimes with interest (called “cumulative
dividends”), before the common stockholders receive anything. Unlike debt, though, preferred stockholders
are not guaranteed interest – they receive dividends just like common
stockholders do, and are subject to some of the risks of the business. So, for example, if the corporation
liquidates and there is not enough money to pay its debts, the preferred
stockholders and the common stockholders will both be wiped out.
You will almost
certainly need an attorney to set up preferred stock for your corporation. Here are some of the things you will need to
discuss with him or her.
First, you need
to determine if your corporation is a subchapter “C” or subchapter “S”
corporation under the U.S. Internal Revenue Code. Subchapter “S” corporations cannot offer
preferred stock to investors, so if you decide to create a class of preferred
stock you will lose your subchapter “S” election and will be taxed as a “C”
corporation.
Second, you will
need to amend your certificate of incorporation describing the rights and
privileges of preferred investors.
Unlike common stock, whose rights are determined by your state’s
corporation statute, you can negotiate with your investors the rights and
privileges they will receive.
Here are some of
the most common rights and privileges you can give your investors:
Voting Rights. Preferred Stock can be voting or nonvoting,
just as common stock can.
Dividend
Rights. Unlike common stockholders, who receive
dividends only when the company can afford to pay them, the holders of
preferred stock are usually entitled to receive dividends in a fixed amount at
specific times. These can either be
“cumulative” (if the company can’t pay them, they get added to the face amount
of the preferred and are paid when the company liquidates), or “noncumulative”
(if the company can’t pay them, they disappear, just as they would for common
stock).
Participation
Rights. A “participation” provision
prohibits the company from paying dividends to its common stockholders without
also paying a dividend to preferred stockholders.
Conversion
Rights. You can give preferred
stockholders the right to convert their shares into common shares at any time,
or upon the occurrence of certain events (for example, a public offering of the
company’s shares or a sale of the company).
This is called an “optional conversion.”
You can also require preferred stockholders to convert their shares upon
a public offering or company sale – this is called a “mandatory conversion”
Exchange
Rights. If your company has issued
debt securities (such as corporate bonds or notes) to investors, you can give
preferred stockholders the right to exchange their shares for debt securities
if it seems unlikely that the company will survive and there will be anything
left over for shareholders after the company’s debts have been paid.
Redemption
Rights. You can give preferred
shareholders the right to redeem their shares (sell them back to the company)
and “cash out” if they are not comfortable with the company’s direction. Similarly, you can require preferred
stockholders to redeem their shares upon the occurrence of certain events.
Priority
Rights. You can create “classes” of
preferred stock. So, for example, if one
investor is putting in $1 million but the others are putting in only $5,000
each, you can offer the large investor “senior” preferred stock, allowing him
to recoup his investment before anyone else if the company goes under, with the
other investors receiving “junior” preferred.
Your preferred stockholders may
also want a seat on your company’s board of directors, the right to review your
company’s books and records, or “veto” powers over major corporate decisions
such as merger, liquidation or the admission of new investors.
Not all of these
options will be appropriate for your company, so be sure to discuss them with a
corporate attorney before you offer your investors anything.
