The Shadow CEO: Stock Classes and Raising Capital

The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.

Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.

Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.

The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.

Stock classes

Most working people have heard the terms common stock and preferred stock. What do these mean? Beware, I have seen some very misleading definitions of these terms. Today, governance and equity have evolved to the point that these two terms mean basically whatever the board wants them to mean.

Historically, common shares were the most basic ones—one vote, and a pro-rata share of the net proceeds of any distribution. Also, historically, preferred shares were those that had special provisions attached. While these provisions were normally positive, they need not be. Therefore, in today’s world of finance, governance, and corporate equities, the board usually defines the meaning of these terms, unless precluded so by the certificate of formation preempting them.

Today you will see some preferred shares with no voting rights and some that have 100 votes per share (termed super-voting rights). You will also see some common shares with no voting rights and others with super voting. Many venture investments yield preferred shares with a liquidity preference. In this case, upon a liquidity event, these shares get a designated return, or payout, before any other shares receive their pro-rata share. You may also see either with special voting rights that give just a particular class the right to approve or disapprove certain actions.

When evaluating transaction agreements be sure to understand the difference between pro-rata and pari-passu.

A company may issue multiple versions of each class of stock, e.g., ‘founders’ common, regular common, Common B, Preferred A, B, etc. The issuance of each specific and different offering of shares is termed a ‘series’, e.g., Series A, B, etc. Early series consisting of only common may be termed Seed Series.

Most frequently, awards or grants under a company EIP will be common stock (but can still be voting or non-voting). Preferred shares are usually reserved for investors, particularly those demanding certain concessions in exchange for their investment—e.g., a liquidity preference, a seat on the board, interest on their investment, etc.

It can be very important how you allocate these types of special provisions to investors. This is a very complex area of finance and governance. A sensible move is to engage an expert early in the company’s life cycle to understand these variations and take a proactive approach to giving the founders, owners, and senior management the maximum flexibility in defining and using these variations.

Raising capital and the distribution of equity

Second only to the founding of a company—and sometimes later surpassing it—raising capital normally has the most dramatic effect on the distribution of equity.

It’s not uncommon for a founder of a startup to own 100% of the issued shares. If there are multiple founders then they have split this up somehow so combined they own 100%. In the eyes and experience of most entrepreneurs, there soon starts an irreversible, and sometimes disturbing, downward trend in their ownership percentage. It may frequently lead to the founders’ loss of control of the company. It may even eventually lead to the founder(s) being ousted from their own company—although usually by that time it is no longer ‘their’ company.

Yes, there are many good investors out there, and yes, there are numerous cases when the founders keep (and sometimes even lose and regain) control for a long time after taking in outside capital—Bezos, Gates, Jobs, Ellison, Dell, Zuckerberg, Yang, Dorsey, Musk, Son, Ma, Page/Brin, and others. However, as notable as this list is, these are exceptions unless they remain completely private and take in a minimum of outside funding.

As previously noted, equity is primarily distributed for founding an enterprise, contributing to one, and investing in one. Raising capital from investors is a very big subject, and the topic of many good books and endless advice from everyone you know—attorneys, investment bankers, other entrepreneurs, venture capitalists, your senior advisors, your junior colleagues, and even guys or gals at the gym.

We will not address here any of the technicalities or strategies for raising early-stage capital. As noted above, there are plenty of books on that. However, it is worthwhile to at least list the most common variety of funding options in vogue today.

Friends & Family: They just write you a check and with a handshake say, “we’ll figure it out later.”
Straight sale of equity (seed or otherwise): involving a term sheet, stock purchase agreement, shareholder’s agreement, SEC Regulation D filing, SEC Rule 506 exemption, etc.
Loan: Promissory Note
Convertible vehicle: Convertible Promissory Note, Simple Agreement for Future Equity (SAFE)

There are any number of strategies and reasons to use one of these tools or many other less-well-known structures. These are the most common, but far from a comprehensive list. And each one has dozens and dozens of variables, options, opportunities, pitfalls, clever workarounds, and potentially ridiculous bone-headed choices to be made. This document does not go there.

Part 8 continues the series.

Note: The information provided in this article does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and materials available below are for general informational purposes only. Information in this article may not constitute the most up-to-date legal, tax, or other information. Readers should contact their attorney or CPA to obtain advice with respect to any particular matter. The views expressed here are those of the author writing in his individual capacity only.

MORE SHADOW CEO

PART 1: Early-Stage Insights for Entrepreneurs

PART 2: Deciding to Distribute Startup Equity? Here’s a Founder’s Guide

PART 3: Using Equity as an Incentive and the Role of the Board

PART 4: What Entrepreneurs Need to Know About the Foundational Documents of a Corporation

PART 5: Equity Distribution Techniques

PART 6: Equity Beyond Stock Options

PART 7: Stock Classes and Raising Capital

PART 8: Determining Startup Value

PART 9: Explaining Common Metrics

PART 10: Calculating Share Price

PART 11: Protecting Founders and Special Voting Preferences

PART 12: Additional Equity Grants

About the author:

Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture capitalist, private investor, author, and consultant, is a long-time board member of some 67 corporate fiduciary boards. In his Shadow CEO® role, he steps in side-by-side with a CEO to help them navigate circumstances and situations on a day-to-day basis.

A version of this column was previously published in Cagan’s “A Primer on Early-Stage Company Equity.”