Valuing Early Stage and Venture Backed Companies

CHAPTER 2

Understanding Early Stage Preferred Stock Rights

Most early stage companies raise external capital through the issuance of preferred stock. Institutional venture capitalists (VCs) and other early stage investors prefer the additional risk protection afforded by preferred stock. This “protection” can be divided between financial and managerial or control protections, all of which have a different impact on applicable discounts, which are discussed in Chapter 6. Make no mistake, though; this preferred stock is not the plain vanilla preferred stock your grandpa and grandma invested in as a safe investment alternative. Rather, preferred shares typically issued to VCs and other early stage investors are often extremely complex financial instruments with unusual and even exotic provisions. It is the interplay of these provisions that make this financial instrument so potent and pervasive among early stage investors.

As we review these provisions individually, it should be noted that their potency and relevance change over time as the underlying investee company progresses through its stages of development. Whereas a liquidation preference may be extremely relevant for a Series A round, it may be much less relevant for a Series E round, where the company is on the verge of a sale or going public. With that in mind, let’s discuss these provisions and their potential impact on early stage company value.

Preferred stock gives its holders numerous rights and privileges that common ...