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.