What Is Shadow Preferred Stock?

“Shadow preferred stock” refers to a series of preferred stock that is created when a SAFE or convertible note converts into stock at a price per share that is less than the price per share for the stock issued in a new equity financing. Shadow preferred stock is essentially identical in most respects to the series of preferred stock issued in the financing—it gives the holder the same voting rights, governance rights, and other rights and privileges of the preferred stock. The key difference is that shadow preferred stock accounts for the discount that the SAFE or convertible security holder receives and adjusts such investor’s liquidation preference to be equal to their original investment.

What is a Liquidation Preference?

When a company completes a preferred stock financing, the certificate of incorporation designates the order and amount paid out to stockholders when a company is sold or dissolved, which is referred to as a liquidation preference. The holders of preferred stock have a liquidation preference that allows them to receive payment before the holders of common stock. That is one of the main rights that makes the stock “preferred.” This liquidation preference is typically set at a rate of 1x the original investment, which means that when the company is sold or dissolved, a preferred stockholder will receive their original investment back, dollar for dollar, before any payments are made to common stockholders.

Back to Shadow Preferred Stock

When a SAFE or convertible note converts into preferred stock at a discount or with a valuation cap, the holders of the SAFE or convertible note would receive an automatic premium to their original investment when the company is sold or dissolved if the SAFE or convertible note were to receive the same liquidation preference as the preferred stock issued to the new investors in the priced round. Shadow preferred is designed to prevent the holders of the SAFE or convertible note from getting a windfall by adjusting their liquidation preference to reflect the lower price per share that they originally paid as compared to the priced round investors.

How is Shadow Preferred Stock Reflected on The Cap Table?

Shadow preferred stock is often denoted on the capitalization table by a numbered subseries to the series of preferred stock for the corresponding priced round. For example, if it is a Series A round, the company will create Series A-1 for the new money investments and Series A-2 will be the shadow preferred for the SAFEs or convertible notes converting in that round. If there are multiple SAFEs or convertible notes converting in the round at different valuation caps or discount rates, there will be multiple series of shadow preferred, which will then be denoted as Series A-3, Series A-4, and so on.

How Else is Shadow Preferred Different?

Like the liquidation preference, the rate at which dividends are paid on the shadow preferred is adjusted to reflect the original amount paid for the SAFE or the convertible note, and this also will be set forth in the company’s certificate of incorporation. Given that dividends are rarely paid by early-stage companies, this adjustment isn’t usually a significant issue for most startups.

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.