What is founders’ preferred stock?
Founders’ preferred stock (also called series FF preferred stock) addresses certain tax and accounting issues that can arise when founders decide to get early liquidity by selling shares of their stock to investors at the same price as other preferred stock sold in a concurrent equity financing (“New Preferred Stock”). In many situations, the company will agree to immediately convert the stock purchased by the investors from the founders into New Preferred Stock.
Ordinarily, founders hold common stock. If they sell shares of common stock for a price in excess of its then-current fair market value (which is typically based on a third party valuation and is well below the value of preferred stock issued by the company), the delta between the sale price and such fair market value could potentially be deemed to be compensatory and treated as ordinary income to the founder. The risk of compensatory treatment is increased in the scenario where the company converts the common stock into New Preferred Stock, as this could be viewed as if the company transferred an exchange right to the Founder in a compensatory transaction. Also, the sale event could be significant enough to impact the value of the company’s common stock going forward, which could impact the value of future option grants.
Founders’ preferred stock is different than common stock because it automatically converts into shares of New Preferred Stock when sold to a third-party investor in connection with a new equity financing. That allows the Founder to sell their founders’ preferred stock for the New Preferred Stock price without any further action by the company. This avoids the argument that the company transferred value to the founder in connection with the transaction, and helps to support the desired treatment of the sale as giving rise to capital gain.* Also, this arrangement helps to avoid the valuation issues that can arise when the founders sell common stock.
*IMPORTANT NOTE: This treatment is far from certain. It isn’t guaranteed that accounting firms, tax advisors or the IRS will agree. However, the general view among practitioners is that the automatic conversion feature of founders’ preferred stock makes the capital gains treatment more defensible than if the founder sells common stock in an early liquidity scenario.
In what cases should you consider founders’ preferred stock?
Founders’ preferred stock is ideal for founders who think they are likely to raise venture capital and will want to get early liquidity, or at least want to leave that option open.
Note that founders’ preferred stock may be frowned upon by some VCs. Founders’ preferred stock makes it easier for founders to get early liquidity, which may not be in the VCs’ interest. Also, if the founders’ preferred stock is not subject to vesting, it is impossible for the Company to repurchase it if and when the founder leaves the company.
If you’ve already formed your company and issued common stock to the founders and non-founders, it might be too late to issue founders’ preferred stock without any tax consequences. A pro-rata issuance of founders preferred generally can be achieved on a tax-free basis, but a non-pro-rata issuance may raise tax issues.
In practice, usually only a portion of founders’ shares are issued as founders’ preferred stock (usually no more than 25%), and the remainder is common stock. Also, while it is possible to impose vesting on founders’ preferred stock, most founders decide to make it fully vested at issuance. Finally, it is best for the founders’ preferred stock to be free from any transfer restrictions that prohibit secondary sales without company approval
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