Successful founders often find themselves stock rich and cash poor, with most of their net worth held in illiquid shares. The usual path to early liquidity is a secondary sale, in which a founder sells a portion of existing shares to investors in connection with a financing. FF preferred stock (also called founders preferred stock or Series FF) is a class of stock adopted at formation to make that future secondary sale cleaner and more streamlined. Despite the name, it generally functions as common stock: it carries no dividend or liquidation preference, and it is distinct from the super-voting share classes sometimes used to concentrate founder control.
How It Works
FF preferred stock has a single distinguishing feature: when sold to investors in connection with a future preferred stock financing, it converts into the series of preferred stock being sold in that round. The investor receives preferred stock rather than common stock, and the founder typically receives the preferred price for the shares. The precise mechanics vary by form. Some versions convert automatically upon the sale, some convert at the holder’s option if the buyer pays the same per share price as the new round, and some require board approval; typical forms also permit conversion into common stock at any time and convert automatically into common stock in a qualified IPO.
Three practical rules follow from the tax analysis. FF preferred stock is generally adopted at formation, when founder shares are first issued; adding the class later can carry tax consequences. It is often, but not always, issued fully vested, because shares subject to forfeiture or repurchase may raise additional tax issues; as a result, any vesting sits on the founder’s common shares. And it typically covers only a modest portion of a founder’s holdings, most often 10 to 25 percent, with the balance in common stock.
Why It Exists
The structure responds to two problems with selling common stock at a preferred stock price. The first is tax. A founder who sells common stock for more than its fair market value (which ordinarily sits well below the preferred price) risks having the excess treated as compensatory ordinary income rather than capital gain, and the risk increases if the company facilitates the sale by converting the founder’s common stock into preferred stock at closing. Since FF preferred stock converts by its terms when sold, no corporate action is required at the time of sale, which is generally viewed as more characteristically the type of transaction that should result in capital gain treatment. However, that treatment is not assured and depends on a variety of factors specific to the underlying transaction; the nature of the security sold is merely one such factor. The second is valuation. A founder sale of common stock at or near the preferred price can put upward pressure on the fair market value of the common stock and, with it, the strike price of future option grants. Alternatively, a sale of FF preferred stock that converts into preferred stock mitigates the repricing effect on the common stock. Note that market practice has evolved on this point: secondary sales of common stock at no or a small discount to the latest preferred round have become customary, and selling parties have found ways to work through the issues that FF preferred stock addresses in its absence. Nonetheless, founders often view the implementation of FF preferred stock as a “just in case” move to improve their chances of a successful secondary transaction in the future.
What to Weigh
FF preferred stock is not the norm. It adds drafting complexity and cost to the certificate of incorporation for a benefit that materializes only if investors are someday willing to buy founder shares, which as a practical matter requires a strong company, an oversubscribed round, and a supportive board. Some investors also read the class as a signal that the founders expect early liquidity, and, when the shares are issued fully vested, the company gives up repurchase rights over that portion of a departing founder’s equity. However, when a secondary sale does happen, the structure may have real advantages: the founder can sell at the preferred price rather than at a discount, the company avoids facilitating a sale of common stock above its appraised value, and an oversubscribed round can be accommodated with less dilution because investors buy existing shares. Additionally, the potential tax consequences of such conversion should be addressed on a case-by-case basis.
In almost all cases, one typical feature of FF preferred stock is that it can convert to common stock at the election of its holder at any time, so founders can always elect to eliminate FF preferred stock at a later time if they find its utility no longer of value. Thus, including FF preferred stock at incorporation gives founders flexibility down the road.
