This is general information, not legal advice
In the most basic ownership (equity) structure, everyone holds the same class of ownership in the company (denominated in “shares” or “units”), with all of the same rights. Each shareholder owns a certain percentage of the company based on the number of shares held relative to the total. If the company is ultimately sold, the proceeds are divided up proportionally.
A one-class structure is simple and easy to document, and may be sufficient in certain limited circumstances – for example, where the contributions of all of the stakeholders are relatively even.
However, it would be unusual for a company that anticipates taking on investment capital to establish this structure. Investment-seeking companies typically need a structure that accords different treatment to the “sweat equity” of founders/senior management and the financial equity (also known as money) of the investors. This is done via the creation of separate classes of stock, each with different rights and preferences: “Common” and “Preferred.”
Money investors receive Preferred stock. Preferred stockholders are entitled to receive the first distributions from the company. Only after the Preferred gets paid are sweat equity investors such as founders and management entitled to share in the profits of the company. It is important to note that when founders put in real dollars – “co-investment,” which is “skin in the game” that outside investors like to see – their investment should be treated the same way as the investor money.
Founders and management – those who are issued equity by virtue of their ideas, initiative and labor – are typically issued Common stock. Common stockholders are are entitled to the “residual equity” of a company, after the claims of lenders and Preferred stockholders are fully paid.
The Basic Two-Class Equity Structures
Here is a quick summary of some of the different possible equity structures.
Single class (common stock only): This is the simplest structure, which may be most appropriate when financial contributions are limited and the founding parties agree that no preferences for any class of owners are needed. All owners have “upside,” because as the value of the company increases, the value of the stock increases.
Straight Preferred and Common: Described above, this structure provides a priority return-of-capital to the financial investors via a Preferred stock. The Preferred stockholders will expect to earn a rate of return (interest) on their investment, which accrues until capital is repaid. Sophisticated investors making significant investments will negotiate a due date (“redemption date”), by which time the company must pay back the Preferred. The noteworthy feature of this structure is that the Preferred stockholders, unlike the Common stockholders, have no “upside” in the company beyond getting their initial investment back with accrued interest. However, in a downside scenario (e.g., a liquidation of the company), their right to get paid first offers them greater protection. This is the basic protection of a straight Preferred, and in some ways resembles being a lender to the Company.
Convertible Preferred and Common: This structure is similar to the above, except that the Preferred stockholders have the right at any time prior to being repaid to convert their Preferred and all accrued interest into Common units. This gives them the opportunity to share in the growth of the company. However, once they convert, they become Common stockholders like all others, losing the preferences of the Preferred stock.
Participating Preferred and Common: This is when the Preferred stockholders get to eat their cake and have it too. Think of a unit of Participating Preferred being equal to one unit of Straight Preferred plus one unit of Common. It combines the superior rights and protections of Preferred stock and the upside of Common.
Debt Analogues to Preferred Stock: It is possible to mimic these Preferred/Common structures using conventional debt in place of the Preferred stock – meaning, a note (loan) instead of simple Preferred stock, or convertible debt rather than convertible Preferred. These structures have some advantages, including speed and simplicity, but also have certain disadvantages to the startup, which we will not cover here. Serial entrepreneurs and venture capitalists thoroughly debate issues like this, for example here and here.
Beyond entitlements to the financial assets of a company, equity classes bear upon other important issues such as governance and control through board membership and stockholder votes and approvals. Where outside investment is minimal, the Preferred is often passive in the governance of the company, with participation limited to major company decisions. Where there is significant outside investment, however, the Preferred may have effective control of the company via voting mechanisms or the right to appont the majority of the board of directors.
Varying the economic and non-economic rights of multiple classes of stock, the number of possible ways to structure a company is virtually infinite. In reality, however, deals tend to get done using a smaller number of typical configurations that prevail in the private investment market at any given time. Even startups that are not raising outside money at the outset may find it worthwhile to establish an equity framework that would accommodate investment at a later time and that communicates a degree of sophistication on the part of the founders.
Attorneys such as GoodCounsel who are experienced in private transactions are familiar with these structures and can offer you appropriate guidance.
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