Startup Negotiations: How Preferred Stock Makes Employee Stock Less Valuable
Originally published February 13, 2014. Updated August 30, 2023.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Common Stock v. Preferred Stock
Startup employees and executives get Common Stock (as options, RSUs or restricted stock). When venture capitalists invest in startups, they receive Preferred Stock.
Preferred Stock comes with the right to preferential treatment in merger payouts, voting rights, and dividends. If the company / founders have caved and given venture capitalists a lot of preferred rights - like a 3X Liquidation Preference or Participating Preferred Stock , those rights will dramatically reduce the payouts to Common Stock in an acquisition. An individual who holds 1% in common stock would be curious, therefore, about the preferred stock’s rights to know if their 1% would really be 1% in an acquisition.
Is Preferred Stock Negotiable for Employees and Executives?
No. Preferred Stock is not negotiable for employees and executives (other than perhaps founders preferred stock which relates not to acquisition payout amounts but to liquidity rights and voting rights). The key is to understand if the investors’ Preferred Stock has unusual, off-market liquidation preferences. If so, that would weigh in favor of negotiating for more shares, more cash compensation or - less often but occasionally - management retention plan terms to make up for uninspiring Common Stock rights.
Liquidation Preference & How It Affects Common Stock Payouts
One Preferred Stock right is a "Liquidation Preference." Without a Liquidation Preference, each stockholder – preferred or common – would receive a percentage of the acquisition price equal to the stockholder's percentage ownership in the company. If the company were acquired for $15 million, and an employee owned 1% of the company, the employee would be paid out $150,000.
With a Liquidation Preference, preferred stockholders are guaranteed to be paid a set dollar amount of the acquisition price, even if that guaranteed payout is greater than their percentage ownership in the company.
Here’s an example of the difference. An investor buys 5 million shares of Preferred Stock for $1 per share for a total of $5 million. After the financing, there are 20 million shares of common stock and 5 million shares of Preferred Stock outstanding. The company is then acquired for $15 million.
Without a Liquidation Preference, each stockholder (common or preferred) would receive $0.60 per share. That’s $15 million / 25 million shares. A hypothetical employee who held 1% of the company or 250000 shares) would receive $150,000 (that’s 1% of $15 million).
If the preferred stockholders had a 1X Liquidation Preference and Non-Participating Preferred Stock, they would receive 1X their investment ($5 million) before any Common Stock is paid in an acquisition. They would receive the first $5 million of the acquisition price, and the remaining $10 million would be divided among the 20 million shares of common stock outstanding ($10 million / 20 million shares of common stock). Each common stockholder would be paid $0.50 per share, and hypothetical employee who held 1% of the company would receive $125,000.
In an up-round acquisition, though, this 1X non-participating preference would not affect common stock payouts. In an acquisition at $100 million valuation, the investors would choose the higher of:
Their $5M liquidation preference and
Their percentage of the company valuation. If they had 20% of the company’s shares, they would of course here choose $20M in payouts. And all common stockholders would also receive their percentage payout.
Ugly, Non-Standard Rights That Diminish Employee Stock Value
The standard Liquidation Preference is 1X. This makes sense, as the investors expect to receive their investment dollars back before employees and founders are rewarded for creating value. But some company founders give preferred stockholders multiple Liquidation Preferences or Participation Rights that cut more dramatically into employee stock payouts in an acquisition.
If preferred stockholders had a 3X Liquidation Preference, they would be paid 3X their original investment before common stock was paid out. In this example, preferred would be paid 3X their $5 million investment for a total of $15 million, and the common stockholders would receive $0. ($15 million acquisition price – $15 million Liquidation Preference = $0 paid to common stockholders)
Preferred stock may also have "Participation Rights," which would change our first example above to give preferred stockholders an even larger portion of the acquisition price.
Without Participation Rights, Preferred Stockholders must choose to either receive their Liquidation Preference or participate in the division of the full acquisition price among the all stockholders. In the first example above, the preferred stockholders held 20% of the company and had a $5 million Liquidation Preference. When the company was acquired for $15 million, the preferred stockholders had the choice to receive their $5 million liquidation preference or to participate in an equal distribution of the proceeds to all stockholders. The equal distribution would have given them $3 million (20% of $15 million acquisition price), so they chose to take their $5 million liquidation preference, and the remaining $10 million was divided among 20 million shares of common stock.
If the Preferred Stock also had Participation Rights, (which is called Participating Preferred Stock), they would receive their Liquidation Preference and participate in the distribution of the remaining proceeds.
In our example with a 1X Liquidation Preference but adding a Participation Right, the Participating Preferred Stock would receive their $5 million Liquidation Preference AND a portion of the remaining $10 million of the acquisition price equal to their % ownership in the company.
$5 million Liquidation Preference + ((5 million shares / 25 million shares outstanding) * $10 million) = $7 million
Common stockholders would receive (20 million shares common stock / 25 million shares outstanding) * $10 million = $8 million.
Our hypothetical employee who held 1% of the company would receive $100,000 (.01 * $10 million) or 0.67% of the acquisition price.
Employee Focus – Quick and Dirty Analysis
These calculations are complicated, so most candidates who are evaluating a startup job offer keep it simple in considering the effects of preferred stock. The quick and dirty way to know if preferred stock is an issue in evaluating an equity offer is to find out:
Do preferred stock investors have any liquidation preferences beyond the standard 1X non-participating preference?
If not, it’s not an issue in any up-round acquisition (and so most startup hires would not be concerned about the preferences at hire).
Founder Focus – Negotiating Your Acquisition Payout
If you are a founder and are negotiating with an acquiror, consider renegotiating your investors’ Liquidation Preference payout. Everything is negotiable in an acquisition, including the division of the acquisition price among founders, investors and employees. Do not get pushed around by your investors here, as their rights in the documents do not have to determine their payout.
If your investors are pushing to receive the full Liquidation Preference and leaving you and/or your employees with a small cut of the payout, address this with your investment bankers. They may be able to help you play your acquiror against the investors so that you are not cut out of the wealth of the deal, as most acquirors want the founders and employees to receive enough of the acquisition price to inspire them to stay with the company after acquisition.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Thanks to investment banker Michael Barker for his comments on founder merger negotiations. Michael is a Managing Director at Shea & Company, LLC, a technology-focused investment bank and leading strategic advisor to the software industry.
