Liquidity

In more challenged private company financing environments, down rounds (i.e., an equity financing at a lower valuation than a prior equity financing) often go from a relatively uncommon occurrence to a more common aspect of many growth equity and venture capital financings. The interrelated impact of geopolitical and macroeconomic events such as valuation resets from post-pandemic highs, public and private market liquidity constraints, prolonged fundraising cycles, and shifts in bargaining power can have profound effects on growth equity and venture capital financing dynamics, making down rounds and valuation pressure more common. Down rounds have significant implications for all participants in the venture ecosystem: founders and management teams, investors, employees, and fund limited partners.

This article focuses on the basic mechanics of conversion price-based anti-dilution protections for convertible preferred stock. Anti-dilution protections need to be considered in the context of the impact on the pricing of the down round in question, and also on the potential impact of future adjustments.

Anti-Dilution Protections

In any equity financing, two types of dilution can occur when a company issues new shares: (1) percentage dilution occurs because the issuance increases the number of outstanding and fully-diluted shares, reducing an existing holder’s ownership percentage if that holder does not maintain their ownership percentage through additional investment, and (2) economic (or price) dilution occurs when a company issues shares at a price that is lower than the conversion price applicable to an investor’s shares, reducing the value of that investor’s position on an as-converted basis.

The conversion price-based anti-dilution protections discussed below are intended to mitigate economic (or price) dilution and the resulting percentage dilution on an as-converted basis. Investors may also help protect against percentage dilution through preemptive rights, which can permit pro rata participation in later financings, whether those are up rounds or down rounds.

Below is a simple illustration of how dilution can occur:

• Before a down round, if Investor A purchased 2,500,000 shares of convertible preferred stock at a price of US$5 per share, and after that financing there were 10,000,000 shares of the company outstanding, Investor A’s US$12,500,000 investment would represent a 25% ownership stake in the company.
• In the down round, the company sells 5,000,000 new shares to investors (other than Investor A) at a price of US$4 per share.
• Following the down round, Investor A continues to own 2,500,000 shares of convertible preferred stock, now out of 15,000,000 outstanding shares of the company, representing a decreased ownership stake in the company of 16.67%, valued at approximately US$10,000,000.

To help protect against the scenario above, Investor A would typically have negotiated for price-based anti-dilution protection when it originally purchased its convertible preferred shares. In a down round, these protections operate to adjust Investor A’s conversion price and therefore the rate at which those shares ultimately convert into common stock. There are two main types of conversion price-based anti-dilution protection: (i) full ratchet and (ii) weighted average.

Full Ratchet

While less common in practice, there has been an increased use of full-ratchet anti-dilution protections to bridge valuation gaps (sometimes, with a sunset date). When used, they can have a profound impact on down-round financing. With full ratchet anti-dilution protection, the conversion price applicable to Investor A’s convertible preferred shares is reset to the new lower price per share from the down round (which is US$4 in the example above), meaning each preferred share from then on would convert into 1.25 shares of common stock.

Now, as a result, if those preferred shares convert, Investor A would own 3,125,000 shares of common stock out of 15,625,000 outstanding shares, meaning Investor A would therefore have a 20% ownership stake (which is less than Investor A’s initial 25% stake, but greater than the 16.67% stake Investor A would have been left with without this full ratchet protection).

Full ratchet protection is not common, but when it does exist, the resulting impact in a down-round financing can be profound.

Weighted Average

Weighted-average anti-dilution protection is far more customary. With weighted-average anti-dilution protection, a formula is used to determine a new conversion price that will apply to existing preferred shares following a down round:

• New Conversion Price = Old Conversion Price * [(X + Y) / (X + Z)]
  • X = the number of shares outstanding on a fully-diluted basis before the down round.
    • Note that the nuances of the X variable are sometimes negotiated, with a company preferring a broader approach (often referred to as the “broad-based” weighted-average formula) that includes all shares on a fully diluted basis, and an investor preferring a narrower approach (often referred to as the “narrow-based” weighted-average formula) that excludes certain types of derivative shares such as options and warrants. The broad-based weighted-average formula is more commonly used.
  • Y = the number of shares that would have been issued to new investors in the down round had the full investment been made at the old price per share (which is US$5 in our example above).
  • Z = the number of shares issued to new investors in the down round at the new price per share (US$4 in our example).

In our example, the resulting math would be:

New Conversion Price = US$5.00 * [(10,000,000 + 4,000,000) / (10,000,000 + 5,000,000)]

• US$5.00 * [(14,000,000) / (15,000,000)]
• US$5.00 * [0.933]
• US$4.67

Under this approach, the adjusted conversion price applicable to Investor A’s convertible preferred shares is now US$4.67, meaning each of Investor A’s preferred shares is convertible into 1.07 shares of common stock.

Now, if those preferred shares convert, Investor A would own 2,675,000 common shares out of 15,175,000 outstanding shares, meaning Investor A would therefore have a 17.63% ownership stake (which is less than Investor A’s initial 25% stake, and less than the 20% stake Investor A would have had with full-ratchet protection, but more than the 16.67% stake that would have resulted without any protection).

Economic Dilution

As mentioned above, conversion price-based anti-dilution protections are designed to reduce the impact of percentage dilution, but they also mitigate economic dilution. Continuing with our example:

• Before the down round, the value of Investor A’s as-converted stake in the company was US$12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$5.00 * 2,500,000)
    • US$12,500,000

• Without any anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to US$10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 2,500,000)
    • US$10,000,000

• With full-ratchet anti-dilution protection, the value of Investor A’s as-converted stake in the company would remain US$12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 3,125,000)
    • US$12,500,000

• With weighted-average anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to US$10,700,000 instead of US$10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 2,675,000)
    • US$10,700,000

Down Round Pricing Must Be Modeled Holistically

These anti-dilution mechanics may be familiar to and understood by most management teams, investors, and advisors, but the practical implications are often not as straightforward. In practice, the negotiated enterprise value, or pre-money valuation, of a company is typically set at the outset of a negotiation, but the resulting per-share price often is not. The per-share price must generally be solved for after giving effect to anti-dilution adjustments, any option pool increase, and the resulting post-closing capitalization. When solving for this price per share, if anti-dilution adjustments would be triggered, the result is that the end-result number of as-converted shares outstanding will be higher than otherwise, which can prompt an iterative calculation. The end-result number of as-converted shares outstanding, and therefore the preferred price per share, must be solved for again.

Existing investors’ anti-dilution protections typically create a direct economic tension with the investors proposing to lead the down-round financing. This is because new investors typically bargain for a specified ownership percentage and expect their investment to buy it. Existing investors may seek to maximize the value of their anti-dilution adjustments. Common stockholders and other unprotected holders, including management and employee option holders, end up bearing much of the resulting dilution and often are most heavily “crammed down.” On the other hand, existing and new investors typically want to ensure that the management team is protected and appropriately motivated, so the option pool increases, the number of end-result fully diluted shares outstanding again changes, and the entire iterative calculation dance begins again. Add in the fact that many down rounds are led by some subset of existing investors, and the tension around the per-share price calculations increases further.

Because of these dynamics, down-round pricing should not be modeled by simply picking a per-share price. Instead, the agreed pre-money valuation, anti-dilution adjustments, option pool increase, and post-closing ownership targets should be modeled together and holistically to ensure that the intended transaction is delivered.

Discussions over a down-round transaction often expand well beyond pricing mechanics and can raise questions about participation, including the potential emergence of a pay-to-play dynamic, board fiduciary duties, voting power, minority equityholder protections, contingency planning for future financing, potential waivers of anti-dilution protections, control-investor risks, the consent process, and the consensus-building required to secure key approvals.

For private companies backed by venture capital investors, acquisition is frequently the most likely path to liquidity. Founders are often laser-focused on product development, market expansion, and fundraising, without devoting the same early-stage discipline to ensuring the company is well-positioned for a future exit via a merger or acquisition.

M&A preparedness is not a late-stage exercise, but an operational strategy to position your company as an attractive, high-value target to potential acquirors.

Corporate Governance

Some of the most common obstacles to efficient M&A processes stem from issues related to corporate governance. Complex capitalization tables, unclear chain of equity ownership, and unresolved governance issues can create transaction delay and, depending on the structure of the transaction, loss of leverage.

Companies should consider focusing on three key areas of corporate governance to be prepared for future M&A processes: capitalization table discipline, stockholder rights, and board and stockholder alignment.

Capitalization Table Discipline

Maintain clear documentation of all equity issuances with proper board and stockholder approvals; confirm board minutes are complete, approved by the board, and signed; verify that 83(b) elections have been timely filed with respect to restricted stock grants to founders and early employees; and ensure 409A valuations are updated following major events that may impact valuation (such as a financing) and, absent such events, at least annually.

Stockholder Rights

Ensure all stockholders have signed the relevant stockholder agreements and that the company’s management team understands the protective provisions embedded within such agreements; similarly, ensure that the company’s management team is familiar with relevant provisions of any investor side-letters (think drag-along mechanics, rights of first refusal, and co-sale rights).

Board and Stockholder Alignment

Understand what approvals are required to approve a sale or merger of the company and whether any investor has blocking rights.

Contracting Discipline

Material contracts, such as key vendor and customer agreements, collaboration agreements, and licensing arrangements, are some of the first diligence requests in an M&A process. These contracts often contain assignment or change-of-control provisions that can require third-party consent, accelerate payment obligations, or trigger termination rights or other contractual rights that could significantly impact the trajectory of a deal. Accordingly, it is important for companies to maintain clear records of all material contracts, ensuring that all contracts are fully executed and include all attachments, exhibits, amendments, and restatements. Companies should track whether any material contracts have upcoming renewals or expiration dates. Additionally, tracking key provisions in such material contracts that may be triggered by an M&A (such as third-party consent requirements) will help streamline the M&A diligence and consent process.

Intellectual property is another value-driver for life sciences companies and technology companies, making it vital for companies to have documentation that clearly delineates intellectual property ownership. Companies should verify that all employees and contractors have signed Proprietary Information and Inventions Assignment Agreements (PIIAAs), review consulting agreements to confirm that intellectual property created by consultants/contractors has been validly assigned to the company, and obtain confirmatory assignments from founders and early contributors, if needed, and at the appropriate time. For companies with affiliated entities, confirm that the company’s core intellectual property assets sit within the target entity and not within any affiliated entities.

Being proactive can save time and expense during the M&A diligence process.

Regulatory Compliance

Depending on industry and geography, regulatory risk can become a gating diligence issue. Companies should identify areas of risk and preemptively resolve any outstanding compliance risks (e.g., data integrity, marketing, industry-specific licensing, etc.). In particular, life sciences companies should consider pursuing regulatory planning with the assistance of healthcare and/or FDA counsel (as needed) to ensure, among other things, that regulatory filings, communications, and approvals are complete and accessible.

Deal Team Preparation

Once the company has decided to start a sale process, identify at the outset who will be part of the core deal team, which will typically consist of a select number of employees and outside advisors. Members of executive management and other key internal personnel with specialized knowledge about the company’s corporate governance, labor and employment practices, employee benefits structure, assets (IP, real estate, etc.), litigation exposure, and regulatory compliance are typically included within the core deal team. Further, at the appropriate time, companies should engage outside advisors, such as outside legal counsel, financial/tax advisors, and investment bankers, all of whom can help quarterback the transaction and efficiently drive the deal process.

After the deal team is in place, consider implementing deal confidentiality procedures to maintain the integrity of the sale process:

• assign code names to the project and company participants;
• limit working group size and access; and
• consider antitrust issues and the use of “clean team” agreements and data rooms.

Data Room Readiness

Prepared companies treat diligence readiness as an ongoing process and not an exercise triggered by a letter of intent or term sheet. First, select a virtual data room that provides strong security and activity tracking. Second, build the company’s data room with organizational discipline, using logical folder structures (corporate, IP, finance, regulatory, benefits, etc.) and uploading documents in a searchable, digital format with consistent document naming conventions. Lastly, in connection with building the data room, flag with the guidance of deal counsel any confidentiality concerns and access restrictions that need to be put in place. For example, are there any documents that need to be redacted or anonymized? Does the transaction present antitrust sensitivity requiring documents to be shared through a “clean room”?

In all, a well-maintained and categorically organized data room significantly accelerates a sale process and signals sophistication to potential acquirors.

The most successful exits rarely begin when a banker is engaged. Ideally, they begin years earlier with strategic and operational foresight. Companies that understand the value of M&A preparedness can preserve negotiation leverage and act more decisively when M&A opportunities arise. After all, engineering an exit is more than closing a deal — it is positioning the company so that the right deal finds you.

In an IPO, due diligence is best understood as the working group’s disciplined effort to (1) identify and assess potentially material issues in the company’s business, history, and financial reporting, (2) translate those issues into accurate and appropriately balanced disclosure in the prospectus and related offering communications, and (3) pressure-test factual assertions so the offering record can be supported if challenged later.

A thorough due diligence investigation is designed to identify not only “problems,” but also facts that could disappoint investors if they emerge later without having been fairly described. Because an IPO is often the first time a company describes its business, results, and risks in significant detail, investors rely heavily on the prospectus as the principal disclosure document when evaluating the company and the investment.

The Due Diligence Investigation Runs from Day 1 Through Pricing and Closing

Companies should begin preparing their documentary data room in advance of kicking off an IPO process by identifying employees with subject matter ownership and assigning responsibility for collecting the relevant materials. Documents should flow to a single point of contact who will ensure materials are loaded into an organized virtual data room.

At the organizational meeting, having a substantially complete data room enables the working group to begin immediately and complete initial document review earlier, allowing diligence to run in parallel with drafting. This helps avoid a common frustration: marketing-forward disclosure drafted early in the process later must be rewritten based on diligence findings. Ideally, the working group incorporates diligence input as the disclosure is developed.

While the most intensive diligence typically wraps up around the initial SEC submission or filing, the work needs to continue through pricing and closing (including effectiveness and any bring-down diligence). New disclosure added in subsequent filings should be vetted, and new information and documentation should be added to the data room on a rolling basis. Maintaining an open issues log, with clear owners, next steps, and deadlines, helps avoid last-minute diligence scrambles that can disrupt the timing of amendments and the overall IPO schedule.

No Surprises

While it may not be enjoyable to share all of the company’s more challenging issues, companies should strive to ensure that underwriters’ counsel is not learning about issues for the first time late in the process. Early identification and resolution also avoids a common dynamic: issues are significantly easier to manage if the company or its counsel shares relevant details early, along with appropriate context, so that matters can be evaluated and framed appropriately from the outset.

This approach also protects against “over-reactions,” where diligence counsel believes it has identified a significant issue and therefore expands review and follow-up. That dynamic can devolve into time-consuming exercises and unnecessary “all-hands” calls, often avoidable where the issue was presented proactively rather than discovered.

Create a Record and Document Support

A thorough diligence record maintained by counsel helps to track progress, monitor efficacy, and create an audit trail in case of a later challenge.

Counsel should maintain a back-up book linking factual statements in the prospectus to supporting sources. Subject matter owners at the company should prioritize responsiveness to support requests and avoid treating the process as a check-the-box exercise.

The process itself should also be documented. Counsel can circulate written questions for diligence calls in advance and cover those questions on the call. A memo should capture attendance, and follow-up items should be tracked to resolution. The open issues log should be shared among the company, its counsel, and underwriters’ counsel and updated regularly.

Don’t Rely on the “Belief” Crutch

One of the most repeated phrases in an IPO prospectus is “we believe.” A statement of belief can be an appropriate way to express judgments or expectations that cannot be definitively verified, and it can help avoid overstating certainty. However, a belief qualification is not a free pass to make claims that are not supportable. Where management expresses a belief, there should be a reasonable basis for that belief and the diligence process should confirm that basis exists and that the disclosure is appropriately calibrated.

For example, a biotechnology company developing a new drug may state in the prospectus: “We believe our product candidate may offer clinically meaningful benefits to patients.” While there may not yet be clinical data demonstrating that outcome, there should be a sound scientific rationale and supporting pre-clinical evidence that provides a reasonable basis for the statement as framed.

Check with Experts

Counsel will review large volumes of material as part of the investigation, but that does not guarantee the working group will fully understand highly technical, specialized, or cutting-edge topics. In appropriate cases, diligence should include calls with relevant subject matter experts (whether technical, regulatory, cybersecurity, accounting, tax, or otherwise) to ensure the record supports the disclosure.

Diligence is More Than Lawsuit Avoidance

A properly conducted due diligence investigation can reduce the likelihood of securities claims for IPO participants. It cannot eliminate the possibility of litigation, but a thorough process can create a defensible record for those who may need it.

The credibility of the working group is also at stake. Underwriters care deeply about successful offerings. Their reputation is their biggest asset and missed diligence issues can cause real reputational harm.

More broadly, accurate IPO disclosure is a long-term asset. Companies will live with their disclosure regime as public companies, updating it regularly under ongoing investor scrutiny. Strong diligence helps public company executives spend more time executing their strategy and less time responding to avoidable surprises.

Moving ahead with an IPO is a major commitment of time and resources. The companies that execute efficiently are the ones that start managing the process well before the organizational meeting by building a realistic base-case timeline, staffing internal owners, and making a small set of initial decisions that drive the critical path.

Construct the Base-Case Timeline Around Key Milestones

A useful approach is to anchor the company’s IPO timeline around three broad windows. At the outset, establish a target IPO pricing date and construct the rest of the timeline to make that achievable. Once determined, establish a target date for the initial confidential submission of the registration statement and a date for the organizational meeting.

1. Readiness planning: preparing for the organizational meeting. The company’s approach to readiness planning can either pave the way for a more efficient process or inadvertently create bottlenecks that cannot be fixed on the back-end. The length of the readiness stage can vary, and more time means better preparation. Completing the key readiness workstreams before the organizational meeting is critical to staying on schedule. As part of readiness planning, companies should identify any third-party consents, waivers, or contractual constraints that may require outreach and turnaround time, because those items can create non-negotiable lead times that compress the schedule later.
2. Confidential execution: organizational meeting to initial confidential submission. This is typically the most drafting-intensive period and often drives internal resourcing needs. The company’s internal IPO team will be heavily engaged in the process and the IPO demands effectively create a second job for them on top of their day-to-day responsibilities. It’s critical that the company’s internal and external staffing is fully engaged and prepared following the organizational meeting.
3. SEC process: initial submission to public filing, launch/roadshow, and pricing. Companies have the least amount of control over this period as it depends heavily on SEC comment cadence and market performance. In practice, a slower or more complex SEC comment cycle can require additional confidential submissions and can also create financial statement update pressure as quarters roll, which can affect both timing and workload. Addressing challenging SEC comments is often best handled in the confidential submission process, which typically means additional confidential submissions and more time, putting pressure on hitting a financial statement staleness window. External factors are rarely predictable in advance, so the best planning will get the company to the public filing on time and enable business leaders to make a go-forward decision on the planned schedule.

Even in a well-run process, timelines move. Treat the company’s base case as a model that gets updated as the process evolves from factors that the company can control toward factors that the company cannot control.

Assign Ownership

Effective IPO execution requires effective organization. The plan and a company’s ability to hit its milestones become manageable with clearly defined internal roles and assignments given to those with the time and resources to properly manage them. A few readiness decisions tend to pay outsized dividends:

• Create a small internal IPO working group. This should include key decision-makers and functional leaders with responsibilities that touch upon the IPO process. The working group should stay in close contact through regularly scheduled meetings with internal and outside counsel to ensure accountability and focus on key workstreams.
• Identify subject matter owners for each workstream. Identify an individual to take ownership of each specific subject matter workstream, including communications, data room management, finance, accounting, legal, compensation, IP, tax, and regulatory, and then make them responsible for the day-to-day management of their workstream.
• Designate a lead draftsperson and a master-document process. Working with the company’s outside counsel, determine a drafting plan for the registration statement with an initial focus on the business section, the management discussion and analysis (“MD&A”), and financial statements. Company counsel can draft much of the registration statement, but someone at the company who has (i) an in-depth knowledge of the company’s business and mission, (ii) drafting and management skills, and (iii) time, should take the lead on overseeing the drafting of the business section. Assigning an owner enables narrative coherence that is not possible with multiple people drafting independently.
• Corporate housekeeping. Assign a tech-savvy person to oversee the due diligence document collection system to ensure the data room is complete and organized. This individual can also serve as a documentation coordinator for cap tables, stockholder consents, lockup signatures, public company policies, and employee education materials.

The practical theme: clarity on ownership of workstreams and tasks prevents the “everyone is responsible, so no one is responsible” dynamic that turns into schedule compression later. Each workstream owner should have clear escalation paths and decision rights (or access to decision-makers) to avoid bottlenecks and ensure key decisions are given the right attention and made at the right time.

Hire Advisors

Companies often treat the banking process as a separate track from readiness planning. It is not. Several early choices directly affect the company’s ability to run a controlled timeline:

• Underwriter selection and coverage strategy. Underwriter selection is one of the most important early decisions because it shapes execution roles, staffing, and investor positioning. In evaluating banks, companies should focus not only on senior coverage, but also on (i) sector fluency, (ii) the experience and availability of the day-to-day execution team, and (iii) the bank’s ability to support the company’s investor narrative through launch and aftermarket. A strong execution bench matters because it directly affects cadence, responsiveness, and how efficiently the working group can run.
• Outside Counsel. The IPO is also an opportunity to confirm that the company will have an IPO-ready legal team with the capacity and continuity to run a fast, iterative drafting and diligence process. Regardless of whether the company uses existing counsel or adds new counsel, the key is to ensure the team has deep IPO experience, the right specialist bench, and the ability to maintain a disciplined process from the organizational meeting through pricing and closing.
• Compensation Consultants. Public company executives are compensated differently than private company executives. Compensation committees will insist on getting high-quality input from experienced compensation advisors before making any compensation decisions. Additionally, structuring public company equity compensation plans is a significant and strategic undertaking. These plans require stockholder approval, which becomes significantly more challenging as a public company, so designing and implementing a plan to take effect alongside the IPO is essential and getting the details right will make life as a public company substantially easier. Lining up the company’s compensation advisors early enables them to give the right guidance at the right time.
• Communications/Investor Relations. While much of the IPO process is governed by what companies cannot communicate, developing a public company story and hitting the ground running as a public company with a functioning Investor Relations (“IR”) infrastructure will make the transition significantly easier. Companies will want IR professionals who are familiar with the story and involved in crafting it so that they can communicate consistently and clearly once public.

A good planning posture is to treat “advisor selection” as a gating item: once selected, the team can finalize the calendar, set drafting cadence, and schedule key events (including analyst education and investor-facing prep).

Financial Statements, Accounting, and Controls

The biggest internal constraint on an IPO timeline is the availability of audited financial statements. The SEC has strict rules regarding the inclusion of audited financial statements in registration statements, and missing a filing window before a staleness date can have significant consequences for execution of a timeline.

Key decisions and actions that typically belong in the earliest phase of readiness planning include:

• Audit readiness and Public Company Accounting Oversight Board (“PCAOB”) planning. It’s never too early to have financial statements audited under PCAOB standards. If a company thinks an IPO in the next two years is a possibility, then there should be a plan to produce the financial statements.
• Identify and resolve complex accounting issues. Complex accounting issues will require careful analysis and likely involve working with the national office of the auditor. It’s a time-consuming process both to analyze and resolve the issue and then complete the audit and draft financial statements. For discrete, high-risk accounting judgments, companies, in coordination with auditors and counsel, should consider early on whether SEC consultation or pre-clearance may be appropriate, as unresolved accounting issues can materially disrupt an IPO timeline.
• Internal controls and Sarbanes-Oxley Act (“SOX”) planning. Developing internal controls is an intensive process that requires an experienced staff and implementation of complex enterprise reporting systems that need to be deployed across the organization. Having a team ready to handle the rigors of public company reporting before going public is essential, and the earlier they are involved, the better.

The practical point: if finance readiness lags, everything becomes reactive. The financial statements and controls work cannot be “crammed” without creating risk.

Plan the Drafting Strategy

The best registration statement drafting processes are the ones where the company arrives at the organizational meeting with (1) a solid draft of the business section that will enable productive drafting sessions, (2) draft financial statements, and (3) a clear drafting plan. A few decisions matter disproportionately:

• Business section planning. This is the most time-consuming drafting exercise and will be the focal point of a substantial portion of the drafting sessions. Arriving at the organizational meeting with a draft that has a clear narrative will make those drafting sessions significantly more productive. It is substantially easier to refine a message in a drafting session than to write new text in a group setting.

There are different approaches to producing the first internal business section draft, and it’s a useful exercise to discuss the company’s plans with outside counsel. The main point is to formulate a plan and see it through all the way to the organizational meeting.

• Material contracts and redaction planning. The company will likely need to file certain material contracts with the registration statement and will likely want to redact commercially sensitive or confidential information from those contracts. This requires coordination with the contractual counterparty for review. As this requires divulging IPO plans to a third party, the timing of this outreach needs to be carefully considered, but it cannot be left until the last minute because it can become a negotiation process.
• Collect source material. If the company expects to cite third-party sources (market data, industry reports) or discuss internal, non-financial metrics, the company should start collecting those sources and consider how they will be used and supported. These are all key diligence materials, and maintaining sources while drafting can go a long way toward running diligence in parallel with drafting to avoid rewriting the business section if later diligence doesn’t check out.

Drafting is time-consuming and is often more challenging than expected. Private companies do not have prospectus-ready disclosure, so a significant amount of content needs to be created, and that content needs to live up to intense scrutiny that comes along with strict disclosure liability in an IPO. Early effort makes it less painful.

The timeline benefit is straightforward: once the narrative architecture and key performance indicator definitions stabilize, drafting cycles compress; until then, each diligence issue and SEC comment is more likely to trigger downstream rewrites that consume time and management bandwidth.

Plan Ahead for Communications

IPO communications restrictions and “quiet period” discipline are schedule issues, not merely legal issues. The company’s communications calendar (conferences, investor touchpoints, press, social media, internal communications) can create avoidable friction if not planned early. Communications discipline is a timeline issue because avoidable public statements, inconsistencies, or unsupported claims can force last-minute disclosure revisions or create heightened scrutiny at exactly the point in the process when timing is most sensitive.

A disciplined approach typically includes:

• Build a communications schedule. The schedule should cover all planned external events during the IPO period and the first months as a public company.
• Calibrate investor communications. Work closely with counsel to only communicate what is permitted and supportable, with particular care around the risk that public statements get amplified by analysts. Be mindful of investor and third-party consents and plan outreach that is not too early and not too late.
• Tighten internal communications. Provide appropriate guidance at key milestones to employees (including the first confidential submission and the first public filing). How early to inform the whole company is a judgment call that can vary depending on the size of the company, but in the pre-organizational meeting stage, it is generally advisable to keep IPO plans to those with a need to know.

The planning theme: communications discipline reduces the risk of last-minute issues that force drafting changes or create unnecessary SEC sensitivity.

A Note on AI in the IPO Process

Generative AI can be useful in producing some of the “boilerplate” sections of the registration statement and can be useful in incremental drafting (paragraphs, not pages) using structured source materials in an iterative manner. Any AI-generated drafting should be verified against source materials and the company’s actual records, because speed without substantiation can create avoidable disclosure risk and rework later in the process. For example, uploading one slide from the company’s pitch deck into an LLM and using a thoughtfully constructed prompt can produce one or two paragraphs of prospectus-style disclosure that can serve as a useful starting point for human-powered drafting.

“Conversion” drafting is also becoming increasingly used. For example, summary financial sections or MD&A tables can be populated from completed financial statements using AI tools. These uses build drafting efficiency, but they are not yet (as of early 2026) revolutionary.

Companies should be mindful of confidentiality when using AI and should ensure that employees are using a closed enterprise system and not a public-facing generative AI tool.

Not every liquidity transaction is a “Tender Offer.” Many private company secondary transactions are one-off, individually negotiated sales of shares by a founder, employee, or early investor to a new or existing investor. These transactions avoid much of the regulatory apparatus discussed in our companion article on Tender Offers, but they are far from unregulated and raise their own legal, tax, and practical considerations for the seller, the buyer, and the company.

Secondary Sales vs. Tender Offers

If a secondary transaction does not meet the definition of a “Tender Offer” (a determination made under the Wellman test discussed in another Catalyst article), the Tender Offer rules – including those mandating minimum disclosures, a minimum offering period, withdrawal rights, and others – will not apply. Instead, the terms of each transaction are negotiated between the buyer and the seller, with the company sitting in the middle as the party whose consent is needed and whose stock records must reflect the transfer.

Documentation and Settlement Mechanics

Secondary sales are typically documented in a secondary stock purchase agreement negotiated between the buyer and the seller. Although such agreements typically follow a similar format, they are usually tailored to the transaction at hand, addressing sale mechanics, representations and warranties, waivers and disclaimers, and any additional rights, and they typically feature company consent, the waiver or expiration of rights of first refusal and co-sale rights, and the allocation of transfer costs and taxes.

Settlement mechanics deserve more attention than they often receive. Because private company shares are not held through a clearing system, closing is a coordinated exercise among the buyer, the seller, and the company (or its cap table administrator), and it can get complicated if the seller must first exercise stock options or convert other securities. In that case, the mechanics must often provide an advance of the exercise price to the seller (whether by the buyer or the company), the company’s processing of the exercise, and the calculation and processing of any associated tax withholdings. The agreement should spell out the sequence of events and the responsibilities of each party clearly; note also that option exercises may take several days to process, so the timeline should be clear and precise.

Securities Law Considerations

Exemption from Registration

As these are still transactions in private company stock, they must be conducted in reliance on a valid exemption from the registration requirements of Section 5 of the Securities Act of 1933 (the “Securities Act”). Because the seller is not the issuer, the question is whether the seller can resell its shares without being deemed an “underwriter.” Two approaches have become the most common over the years:

1. The “Section 4(a)(1½)” exemption: Historically the most commonly used exemption, especially prior to the introduction of Section 4(a)(7), this is a product of practice and case law rather than statute. The idea is that a resale by a non-issuer should be exempt under Section 4(a)(1) (which exempts transactions by persons other than issuers, underwriters, and dealers) so long as it is conducted in the manner required of an issuer’s private placement under Section 4(a)(2): generally, a sale to a limited number of sophisticated or accredited purchasers with access to information about the issuer, with no general solicitation and with the purchaser taking the shares for investment. The full list of conditions is longer, and although the Section 4(a)(1½) exemption is typically viewed as a well-trodden path, it requires careful analysis and structuring of each transaction. Note also that there is no statutory safe harbor and no preemption of state blue sky requirements when this exemption is invoked.
2. Section 4(a)(7): Added to the Securities Act by the FAST Act in 2015, Section 4(a)(7) effectively codified the Section 4(a)(1½) exemption into the Securities Act, although it introduced a number of additional requirements (including that each purchaser be an accredited investor, that no general solicitation be used, and that the securities have been outstanding for at least 90 days). Notably, where the issuer is not a reporting company, the seller must make available to the purchaser prescribed information about the issuer, including a description of its business, the names of its officers and directors, and its most recent balance sheet and two years of income statements. Securities sold under Section 4(a)(7) are “covered securities” exempt from state registration requirements, although they remain restricted securities in the buyer’s hands. Section 4(a)(7) was not intended to invalidate the Section 4(a)(1½) exemption when it was introduced and is typically viewed as a more certain path to an exemption for individual secondary transactions.

There are other exemptions that may be available to sellers, including Rule 144, but these are much less frequently used due to compliance complexity and limited availability in light of the typical structure of such transactions.

Antifraud – Rule 10b-5

Secondary sales are frequently marked by an asymmetry of information between the parties. An employee seller may know the company’s operations but not its financing plans; an investor buyer may sit on the board and know both. Whatever the direction of the asymmetry, Rule 10b-5 still applies to the purchase or sale of any security – public or private – and prohibits material misstatements and omissions in connection with the transaction. Insiders who trade with less-informed counterparties while in possession of material nonpublic information face real exposure, as does a company that facilitates such a trade. Parties commonly manage this risk through “big boy” letters and non-reliance provisions, in which each side acknowledges that the other may possess undisclosed material information. These provisions help but are not a complete defense, as their enforceability often turns on the facts and circumstances and their specific wording. As with Tender Offers, any information material to an investment decision should be disclosed to both parties before they commit to the transaction (including by the company, even though it is not a direct party to the transaction).

Corporate Law Considerations

Transfer Restrictions and Protective Provisions

Many VC-backed companies restrict transfers of their shares to third parties. These restrictions typically include a right of first refusal in favor of the company and major investors, co-sale rights, a board consent requirement, and – especially for preferred stock – protective provisions requiring the approval of a majority of the preferred holders for specified actions. Each must be reviewed, waived, or complied with before closing. Protective provisions are easy to overlook: a transfer of shares, a repurchase, or other distribution by the company on account of its stock, or a sale large enough to change the outcome of a class vote may require consents beyond the board. Larger sales should also be checked against “Deemed Liquidation Event” definitions and interested party transaction rules.

Capital Impairment and Distribution Requirements

Where the company itself is the buyer, the transaction is a repurchase and is subject to statutory limits on distributions. Under Delaware law, for example, a corporation may not repurchase its shares when its capital is impaired or when the repurchase would cause impairment, and directors who approve an unlawful repurchase face personal liability. Debt agreements and preferred stock terms frequently add restrictions on repurchases and restricted payments. A company repurchase should therefore be supported by a board determination of available surplus and reviewed against all contractual covenants and protective provisions.

Using the Company’s Consent as Leverage

Because the company’s consent is almost always required, a secondary sale is an opportunity for the company to tidy up its relationships with both the incoming buyer and the departing seller. Companies regularly condition consent on the following:

1. Additional obligations on the buyer, including:
   1. A joinder to the company’s voting, right of first refusal and co-sale, and drag-along agreements, often without the information or registration rights afforded to lead investors.
   2. A market standoff or lock-up agreement in anticipation of an IPO.
   3. Confidentiality obligations and limitations on further transfers of the shares, including to competitors.
2. Releases and confirmations from the seller, including:
   1. A general release of claims against the company.
   2. Confirmation of the seller’s remaining equity, if any.
   3. Reaffirmation of confidentiality, invention assignment, and other continuing obligations, particularly for current and former employee sellers.

Tax Considerations

Tax consequences to both the seller and the buyer deserve special attention and are too often addressed only after the price has been agreed. For the seller, the central questions are whether the gain is capital or ordinary, whether the holding period qualifies for long-term treatment, and whether the shares are qualified small business stock eligible for the Section 1202 exclusion (i.e., QSBS). Employee sellers face additional issues: a purchase price above the company’s most recent 409A valuation may be treated in part as compensation; shares acquired on exercise of incentive stock options may suffer a disqualifying disposition; and so on. Both sides should understand these issues before the price is set, and structuring matters. Parties also often negotiate separate tax obligations and indemnities directly into the agreement.

Secondary sales offer flexibility that Tender Offers do not, but that flexibility comes with the burden of getting each transaction right individually. While that burden is real, it also carries a benefit: the parties can be more thoughtful about structuring, and the company can control timing and negotiate for terms that benefit it.

Despite cautious optimism following an upturn in biotech M&A in mid-2025, development-stage biotech companies continue to face significant financial headwinds including increased layoffs, higher borrowing costs, healthcare pricing reforms, and ongoing market correction following the pandemic-era investment boom. Companies should take proactive steps to build financial resilience: routinely identifying clinical and regulatory inflection points that could threaten liquidity; maintaining robust contingency plans that account for insolvency regimes in all relevant jurisdictions; engaging in fact-finding during periods of financial health to identify potential cash shortfalls; evaluating hypothetical liquidation scenarios early to understand timing and resource requirements; running structured strategic alternative processes (including asset sales, mergers, or licensing deals) well before reaching a crisis point; and budgeting for the time and cost of navigating financial distress, including the reality that dissolution processes can take three or more years to complete.

On April 16, 2026, the Division of Corporation Finance (Division) of the U.S. Securities and Exchange Commission issued an exemptive order (Order), effective immediately, that changes certain rules pertaining to tender offers of securities. The Order covers tender offers for both reporting and nonreporting companies.

The Division’s stated rationale for the Order is threefold: (1) to address market inefficiencies created by the 20-business-day minimum offer period; (2) to reflect technological advancements that enable faster dissemination of, and access to, offer materials; and (3) to reduce offerors’ and security holders’ exposure to unnecessary market fluctuations during the offer period.

Shorter Offer Period for Private Companies

Most notable in the Order, tender offers conducted by private companies, as well as by wholly owned subsidiaries of such issuers for the issuer’s own securities, will now be subject to a 10-business-day minimum offer period.

There are some conditions for this new relief to apply:

• Cash-only, fixed-price consideration. The consideration offered must consist solely of cash at a fixed price.
• Early notice of price or percentage changes. Any change to the percentage of securities sought (beyond the 2% de minimis threshold) or to the amount of cash offered must be communicated to holders no later than 9 a.m. Eastern time on the fifth business day before expiration.
• Notice of other material changes. Any other material change in the terms of the offer must be communicated no later than 9 a.m. Eastern time on the second business day before expiration.

Notably, the Order does not grant any relief to third-party led tender offers, which is expected to result in a clear timing advantage for issuer-led liquidity transactions for private companies.

Shorter Offer Period for Public Companies

For third-party tender offers subject to Regulation 14D, a shortened 10-business-day period is available but only when (i) the offer is made pursuant to the terms of a negotiated merger agreement or similar business combination agreement between the target company and the offeror and (ii) the offer is made for all outstanding securities of the subject class. In addition, the target company must file and disseminate a Schedule 14D-9 no later than 5:30 p.m. Eastern time on the first business day following commencement.

By contrast, for issuer self-tenders subject to Rule 13e-4, the abbreviated period is available when the offer is made for less than all outstanding securities of the subject class.

Conditions Applicable to All Public Company Tender Offers

Regardless of whether the tender offer is a third-party offer or an issuer self-tender, all of the following conditions must be satisfied:

• Cash-only, fixed-price consideration. The consideration offered must consist solely of cash at a fixed price.
• No going-private transactions. The offer must not be subject to Exchange Act Rule 13e-3.
• No cross-border exemptions. The offer must not be made in reliance on the cross-border exemptions under Exchange Act Rule 14d-1(d) or Rule 13e-4(i).
• No competing offer at launch. At the time the offer is publicly announced, the subject securities must not already be the subject of another pending or previously announced tender offer by a different offeror.
• Extension required if a competing offer emerges. If a competing tender offer is publicly announced after commencement, the initial offeror must extend its offer so that it remains open for at least 20 business days from the date it originally commenced.
• Press release with hyperlink at launch. The offer must be announced via a widely disseminated press release or wire service by 10 a.m. Eastern time on the commencement date, including basic terms (identity of offeror, class of securities, consideration, and expiration date) and an active hyperlink to a website where holders can access the tender offer materials.
• Early notice of price or percentage changes. Any increase or decrease in the percentage of securities sought (beyond a 2% de minimis threshold) or any change in the consideration offered must be publicly announced no later than 9 a.m. Eastern time on the fifth business day before expiration.
• Notice of other material changes. Any other material change in the terms of the offer must be publicly announced no later than 9 a.m. Eastern time on the second business day before expiration.

Key Takeaways

The Order offers meaningful practical improvements for liquidity transactions structured as tender offers.

Most significantly, and in light of the increased prevalence of liquidity transactions, including tender offers, in tech among privately held venture capital and private equity-backed companies, parties should now give serious consideration to the meaningful timing advantage that an all-cash issuer-led tender offer would present as compared to other structured liquidity transactions. In addition, for public companies, the Order now offers greater flexibility in aligning tender offer timelines with other typical deadlines that arise in such transactions, including proxy timelines, antitrust, equity compensation, and the Committee on Foreign Investment in the United States.

Of course, the Division expressly noted that all antifraud and antimanipulation provisions of the federal securities laws continue to apply — including Sections 10(b) and 14(e) of the Exchange Act and the rules promulgated thereunder — and that responsibility for compliance with all applicable federal securities laws rests with the offeror.

The last few years have seen a wide proliferation of secondary liquidity programs among VC- and PE-backed technology companies. Late-stage private company VC and growth financings now typically feature a secondary component, and it is not unusual to see secondary-only transactions among revenue-positive technology companies. The wide adoption of these transactions has brought with it a changing landscape of liquidity timeline expectations, valuations, and terms. Additionally, these programs often require careful structuring and a variety of legal and business considerations that are novel even to many experienced executives in technology companies.

Tender Offers vs. Secondary Transactions

When a high-growth company begins thinking about providing liquidity to its shareholders while it is still private, the first question that arises is whether the proposed transaction will be a “Tender Offer” (a legal term that brings with it a number of additional regulatory requirements) or a one-off secondary (a less regulated bilateral agreement between two parties). The determination is often made by legal counsel with reference to the Wellman test, a fairly dated eight-factor legal test that stems from a case called Wellman v. Dickinson. That said, the Wellman test is fairly straightforward and most of the eight prongs are usually met in a “typical” secondary program, in which case the analysis often comes down to the first two prongs, which are determined by reference to the number of potential eligible sellers and what percentage of the overall outstanding company capitalization they represent. The standard is subjective and depends on facts and circumstances – for instance, if an offer is made to hundreds of shareholders representing 10%+ of the company’s outstanding capitalization, you are most likely looking at a Tender Offer.

Tender Offer Rules

Tender Offers implicate U.S. corporate, tax, and securities law, and can equally implicate foreign laws when the eligible sellers are abroad. Private company Tender Offers, however, do offer significantly more flexibility than public company Tender Offers (i.e., no schedules, no SEC review, and more structuring flexibility with respect to the offering terms):

Securities Law

Section 14(e) of the Securities Exchange Act of 1934 (the “Exchange Act”), including the antifraud and antimanipulation provisions contained therein, as well as the extensive rules and regulations promulgated thereunder, including Regulation 14E, must always be considered and consulted when conducting a Tender Offer. Most notably, Tender Offers typically require a disclosure document, a reasonable means to tender the securities, and a minimum open period during which eligible sellers can consider whether or not to participate in the Tender Offer.

It is important to note that, on April 16, 2026, the U.S. Securities and Exchange Commission (SEC) issued an exemptive order that changed some of the rules pertaining to Tender Offers, including the minimum offering period for offers conducted by the company itself rather than directly by a third-party purchaser. An article summarizing these changes is also available on Sidley Catalyst.

In each jurisdiction where an offer is made, including foreign jurisdictions and any relevant U.S. state, local securities laws should also be reviewed.

Corporate Law

Tender Offers conducted by a third-party purchaser implicate corporate law governing transfers of securities and, as is typical for VC-backed technology companies, potential transfer restrictions. Tender Offers may also inadvertently trigger “Deemed Liquidation Event” provisions in the company’s governing documents.

Tender Offers conducted by the company that issued the securities in the first place may implicate rules concerning repurchases or redemptions of securities, impairment of capital, and dividends.

Of course, shareholder protective provisions and other restrictive covenants in equity and debt agreements must be consulted.

Lastly, Tender Offers often implicate interested party and corporate opportunity considerations, as executives and board members are also often eligible to participate, and careful consideration must be given to cleanse any such issues via relevant corporate law provisions.

Tax Law

Tender Offers require extensive tax planning, both with respect to the impact on eligible sellers and on holders of stock options or other employee equity. Section 409A deferred-compensation rules, dividend rules, compensatory versus capital gains treatment, and other tax rules may all be implicated if not carefully structured. It is typically expected that eligible sellers will receive some level of disclosure with respect to potential tax implications of their investment decision.

Structuring Considerations

There are two primary decisions that any company contemplating a Tender Offer must consider at the outset:

1. Eligibility Criteria. Who should be eligible to sell their securities in the Tender Offer? A number of factors are typically considered here, including:
   1. Will the Tender Offer proceeds have a positive or negative impact on employee retention?
   2. Are there early investors who require returns for their funds?
   3. Will there be a “consolidation” effect on the cap table? Will some shareholders be happy to sell and separate from the company sooner than others?
   4. Will there be an expectation of continued liquidity programs?
   5. Will there be a positive or negative impact on the company’s valuation?
   6. How will this impact public perception of the company and its shareholders?
2. Identity of Purchasers. Will this be a direct third-party purchase by a single purchaser or a group of purchasers, or will it be conducted as a repurchase by the company of its own securities? The differences between the two can impact the following:
   1. Time period required for the Tender Offer to remain open.
   2. Primary responsibility for preparing the Tender Offer documents and for the accuracy of those documents.
   3. Difference in fees and costs associated with the Tender Offer.
   4. Whether the company has funds to conduct the Tender Offer or whether such funds must be raised from third-party sources.

Less pressing, but nonetheless important, considerations include which party will pay the fees and costs of the Tender Offer, whether the purchaser will require additional investor rights or side letters, whether any third-party portals or paying agents will be used, and how decisions regarding eligibility, extensions, and the like will be made.

Pricing the Tender Offer

The price offered for the company’s securities in a Tender Offer is often the result of negotiation. That said, there are a few considerations that repeatedly come up as the potential purchaser is considering what price to set for the Tender Offer:

1. The price paid for the company’s securities in the most recent fundraising round. Law firms, secondary market platforms, banks, and others with significant experience in these transactions now have plenty of statistics to share with their clients regarding typical pricing for Tender Offers vis-à-vis the last round, how much time has passed, any discounts, and so on.
2. The likely impact on future fundraising and liquidity opportunities. Tender Offers in companies nearing a liquidity transaction are very common, and pricing in the Tender Offer may indicate the likely valuation the company’s securities will receive in an IPO or M&A transaction. Thus, the pricing serves as a “signal” out to the marketplace as much as to the selling shareholders.
3. The likely impact on the shareholder base. If the company’s shareholders have been signaled for years that they are holding very valuable stock, a discounted price in the Tender Offer may lead to disappointed employees and investors, even though the offer may look like a great deal to the purchaser.
4. Impact on equity incentives. A highly priced Tender Offer may have an impact on the valuation of the company’s securities, including the exercise price of its stock options and the value of its RSAs and RSUs. Depending on which securities are used for equity incentives at the company, the price paid for securities by a third party may require a change of course after the transaction. Companies may also want to consider an exercise or grant freeze during the Tender Offer period, which may impact the company’s ability to hire or retain talent while the offer is open.

Timing and Disclosures

Finally, any company considering a Tender Offer must do so in the context of potential upcoming major transactions, changes in leadership, launches, or other major events that would be viewed as material to an investment decision and therefore would require disclosure to the eligible sellers. Typically, as well, some level of financial information is provided as part of the Tender Offer disclosures, and companies often think about the publicity and timing implications of this. As such, the likely timing of the offering and how it fits within the company’s and the investors’ broader timelines is an important consideration that should be proactively addressed prior to the launch of any Tender Offer.

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.