MaRS Library Convertible preferred stock: How investors maximize their return on investment (ROI)
Make sure that you understand the features of convertible preferred stock to fully assess how much value you will receive upon liquidation or exit from your venture.
You may receive a great valuation. You may also feel that you are giving up a (relatively) small ownership stake in your venture. Still, this does not mean that you are getting the best possible deal.
How investors maximize their return on investment (ROI)
Once venture capital investors (VCs) invest in a private company, their capital is tied up. Without systemic shareholder protection (such as the public markets, which are subject to rules and regulations and provide liquidity for the stock), the VC can be subject to the unpredictable decisions of a board and management. For this reason, most investors in a private early-stage company will buy convertible preferred stock.
Advantages of convertible preferred stock
In a liquidation event, preferred shareholders are paid before common shareholders. The stock’s ranking also determines how the pie will be divided among the shareholders. Just because you own a specific percentage of ownership in the company, it does not mean that you will receive that percentage of the proceeds.
Preferred stock provides shareholders with a high level of control
Investors typically have vetoes over major decisions within the corporation. Preferred shareholders must approve certain restricted transactions and protective covenants. Issues that VCs will seek to control include:
- Selection and removal of the CEO
- Executive compensation
- Increasing the amount of permissible debt
- Issuing additional stock
- Changes to the rights and structures of the stock
- Establishing or modifying the Employee Stock Option Plan (ESOP)
- Any acquisition, sales or mergers
Preferred shareholders also have the right to appoint members to the board of directors, providing them with influence over the company’s strategy. However, the primary responsibility of a board member is the fiduciary duty to the company. This overrides any responsibility that the director may have in relation to the investor.
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Houston, T., Johnson, A., & Smith, E. (2006, September 15). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors.Retrieved April 9, 2009, from Fraser Milner Casgrain website at http://www.techstartupcenter.com/
Berkery, D. (2008). Raising Venture Capital for the Serious Entrepreneur. New York: McGraw-Hill.
Cardis, J., et al. (2001). Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. Toronto: John Wiley & Sons.