The Business of Venture Capital, 3rd Edition

27Buy Low, Sell High: Equity Preferred Stock

When any corporation is incorporated, the founders contribute capital and designate a certain number of shares. While at the time of formation only one class of shares may exist, typically common shares, this may change when investors come into the picture. Preferred stock is a separate class of shares for investors, which enjoys control and financial preferences over and above the common shareholders.

If the value of preferred stock grows, the ability to invest additional amounts of capital, such as with preemptive rights, helps investors maintain or build their position in a growing company. If it sours, the ability to gain control (via management changes), minimize the impact of downsides (via antidilution), and attempt to salvage the remains of the day is important. In reality, most practitioners agree that if any opportunity teeters, not much can be done to resurrect the remains. In any portfolio, at least a third of the investments will likely end up as write-offs.

Structuring an investment starts with valuation primarily, followed by liquidation and antidilution preferences (used to protect ownership), dividends, and rights of first refusal, or ROFR (pronounced as rofer, which sounds like an angry dog). These terms aligned effectively can help any investor (a) establish an ownership position and (b) build up ownership as the opportunity progresses. The lead investor, the one with the maximum investment amount in the round, ...