What is Founder Preferred Stock? Is it a good fit for my startup?

TLDR: Founder preferred stock (also known as "Series FF" preferred stock) is a special class of common stock that can be converted into a later series of preferred stock as part of a future financing round. These unique aspects create complications that make founder preferred stock a poor choice for most startups.

Founder preferred stock can be a useful tool for founders as it gives them to the ability to convert some of their holdings into preferred stock that can then be sold to other preferred stockholders as part of an equity financing. This provides liquidity for early-stage founders who might be stock-rich but cash-poor. 

However, there are other ways to provide founders with liquidity and founder preferred stock has become less popular in recent years due to the drawbacks discussed below.   

Characteristics of Founder Preferred Stock. Here are some common features of founder preferred stock:

• Founder preferred stock is essentially identical to common stock except that it is convertible at the option of the holder into the same series of preferred stock issued in a subsequent round of equity financing if the buyer purchases it in connection with the equity financing.
• The conversion into preferred stock can only occur if the buyer of the founder preferred stock pays the same price per share as the shares of preferred stock sold in the equity financing.
• Like preferred stock, founder preferred stock is convertible into common stock at any time at the option of the holder.
• Founder preferred stock automatically converts into common stock upon a qualified IPO or upon the consent of holders of a majority of founder preferred stock.

Drawbacks. However, founder preferred stock is typically less favored than more common equity incentives (such as stock options or restricted common stock) for a number of reasons:

• Pricing of the stock is complicated.
  • Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). If the founder preferred stock is not issued at initial incorporation, then issuing the founder preferred stock at a later point in time will require the founders to pay more than a nominal amount to purchase the shares.
  • If the founder preferred stock is issued immediately prior to a Series A financing, then the price per share of the founder preferred stock probably should be at least the same as the Series A stock. In some respects, the founder preferred stock may be more valuable than the Series A stock in the future if it can convert into a later round of preferred stock with a liquidation preference greater than the Series A. On the other hand, there is significant risk that the holder never receives liquidity because investors may not be willing to purchase the founder preferred stock.
• Legal fees incurred in issuing founder preferred stock may be higher. This is because implementing founder preferred stock requires some amount of custom drafting and tweaking compared to a typical incorporation with a standard equity incentive plan. In addition, many attorneys are not familiar with the concept and there are costs incurred in “reinventing the wheel” and getting all parties comfortable with the structure. The additional costs involved in setting up the founder preferred stock may be wasted if the founders are later unable to find investors willing to purchase the equity.
• Implementing the founder preferred stock before an equity financing sends a message to potential investors that the founders want liquidity in connection with an equity financing. This may not be wise to mention when looking for early rounds of financing. However, venture funds may be willing to allow founders to sell in a secondary transaction in the following situations:
  • The venture fund has to agree to it because there are multiple terms sheets in a competitive deal.
  • The company is doing well (i.e., valuation is well above $100M and nearing an IPO) and the founders would rather sell now than wait longer for liquidity.
  • The founder has a compelling personal need for liquidity.
• Other mechanisms exist to allow founders to receive liquidity in connection with a venture financing. Companies or third parties can purchase founders' common stock for cash, subject to various limitations and tax implications. The main issue the founder preferred stock solves is the price difference between preferred stock and common stock. If common stock is purchased by the company or third parties at the same price as preferred stock is being sold to investors, then the fair market value of the common stock for option pricing purposes should be affected by this secondary transaction. However, valuation firms do not currently place significant weighting on secondary transactions. Therefore, the founder preferred stock probably only incrementally solves for a situation where founders want liquidity and want to preserve a significant price difference between the common stock and preferred stock in an early-stage venture financing.
• Other employees may be upset that founders are receiving some liquidity when these employees hold stock options or common stock that are illiquid.
• There is some risk of claims against the founders that sell (and the Board) if the company never reaches a liquidity event. The other stockholders (including disgruntled employees) might argue that the company should have issued new shares to the investors and received the funds that the founder received from selling the stock.

Founders should carefully consult with their attorneys when considering whether to add founder preferred stock to their startup’s capitalization structure. Most likely, there is a simpler way to provide founders with liquidity.

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