Preferred Stock Mechanics and Definitive Documents

You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.

The topics below are important elements of a preferred stock financing. These issues may or may not be represented in the term sheet.

Preferred Stock Conversion

In early-stage company financings, preferred stock is almost always convertible into common stock at the option of the holder. It is also typically converted automatically upon an event such as an initial public offering that meets a certain size, or upon the election of a majority (sometimes supermajority) of the preferred stock to convert to common. This clause in the term sheet will typically specify the conversion ratio of preferred stock into common stock (always at a 1:1 ratio) and any events or other provisions that would impact that conversion ratio. For example, take a look at the Series Seed Term Sheet, which says:

Subscription Procedure

Subscription procedure refers to the documents you as an investor will be asked to sign. In a preferred stock financing, the documents you will be asked to sign will depend on what type of preferred stock is being sold. If it is a Series Seed Preferred round, you might just be asked to sign the Stock Investment Agreement. If the round is a Series A or beyond, you will probably be asked to sign a number of documents, including:

• a Stock Purchase Agreement,
• an Investors’ Rights Agreement;
• a Voting Agreement, and
• a right of first refusal and co-sale rights.

Capitalization Representation and Warranty

In a fixed-price financing it is critical that the company and the investors have clarity on the ownership of the company’s capital stock. Without clarity it is impossible to determine the price per share. There is usually a representation and warranty in the stock purchase agreement in which the company represents and warrants to the investors the current capitalization of the company.

Fixed Price Round Following Convertible Round

If you are investing in a fixed price round in a company that has convertible debt outstanding, you will want to make sure the convertible debt converts when you invest. This is accomplished by adding a condition to the closing that all convertible securities must convert. Otherwise, your interest will be subordinate to the outstanding debt of the company.

Preferred Stock Definitive Documents

For a preferred stock deal, the definitive documents will include, at a minimum:

1. A preferred stock purchase agreement, including any disclosure schedules which may be attached to the stock purchase agreement.

2. An amended charter, or amendments to the company’s charter (a preferred stock financing requires that the company’s charter be amended to include such things as the liquidation preference per share, the anti-dilution adjustments, protective provisions).

3. If there are ongoing investment rights such as the right to a board seat, information rights, et cetera, then there will be a shareholder agreement of some kind, such as an Investor Rights Agreement, a Voting Agreement, and so on.

Disclosure schedules are attachments to a stock purchase agreement in which the company discloses any items required to be disclosed on the schedule. If you are not familiar with stock purchase agreements, the representations and warranties are written in absolutes. The disclosure schedules are there to provide the details. Disclosure schedules are important to review as part of your diligence before signing the definitive documents.