What Kind of Stocks Would You Issue for a Startup?

Deciding between issuing common or preferred stock in India is vital for any startup. It is a crucial decision that will determine how much control you’ll retain and your ability to raise capital. 

In this article, we will learn equity structures, voting rights, dividends, preferences, stock option plans, classes of shares, and more to help you craft a startup equity structure that aligns with your objectives. 

Read on to gain practical insights on architecting your capitalisation table.

Common stock

Holding common stock in a startup isn’t just an investment; it’s a leap into the heart of the venture, where your voice matters in pivotal choices sculpting the company’s destiny. Your input matters when it comes to voting for the board of directors or deciding on potential mergers with other businesses. It is worth noting that the power of the founders can decrease if the company issues too many common shares. 

Nevertheless, this can be avoided by maintaining a delicate balance between issuing new shares and keeping the founders in control. It is an exciting time to invest in a startup and be a part of its growth and success.

Upsides:

• Aligns incentives between shareholders and founders
• Provides capital without fixed dividend commitments
• No major ownership dilutions are reserved only for employees

Downsides: 

• Voting rights dilute founders’ control 
• Less protective provisions for investors

Preferred stock 

When a company starts, it needs money to grow. Investors can provide that money by buying stocks in the company. Preferred stock is one type of stock that investors can buy. It is called “preferred” because it gives investors some special rights and protections that regular stock doesn’t have. 

For example, if the company goes bankrupt, preferred stock investors get their money back before regular stock investors do. However, preferred stock investors usually don’t get to vote on important company decisions like regular stock investors. 

This can be good for the company’s founders, who want to keep control while still getting the money they need to grow the company.

Upsides

• Fewer voting right assurances enable founders to raise more capital while retaining control
• Liquidation preference minimises the downside for investors
• Special investor rights on key decisions

Downsides

• Commitment to pay preferential dividends can strain cash flows
• Complex cap table with multi-class instruments
• Excessive preferences can significantly dilute founders’ equity

Key features of preferred stock

1. Liquidation preference: Investors get paid before common shareholders in an exit or bankruptcy event

2. Dividend preference: Fixed dividend right over common stock shareholders (Cumulative or non-cumulative)  

3. Conversion Rights: Option to convert preferred shares to common stock  

4. Participation rights: Preferred shareholders share pro-rata in common shareholders’ proceeds after recouping their liquidation preference amount

5. Anti-dilution provisions: Protects economic share if more shares are issued at lower valuations

6. Special voting rights: Preferred shareholders’ voting rights on key decisions 

Participating vs non-participating preferred stock

This determines preferred shareholders’ participation in common stockholders’ returns. Participating in preferred stock allows holders to recoup liquidation preference and subsequently share the remaining sale proceeds with common shareholders. Non-participating entitles holders to only liquidation preference and dividends.

Participating in preferred stock minimises dilution for founders.

Types of common stock

While the preferred stock is issued to investors, founders primarily utilise common stock. However, issuance considerations exist here, too. Startups can create sub-types of common stock through: 

1. Vesting Provisions: Rules regarding the percentage of stock vested over time of employment

2. Founder Stock: Motivates founders to grow business for maximum sale value 

3. Management Pool: Reserved for future allocation to management talent

4. Employee Stock Options: Compensates early team members through the potential for shared upside  

Dual-class share structures 

Technology companies often use dual-class structures with Class A and Class B shares carrying asymmetric voting rights. For example, Class B shares provide 10 votes per share, while Class A provides just 1 vote per share. Founders retain the majority of Class B shares, while new investors get Class A shares. This enables founders to get growth capital without ceding control.

However, dual structures limit the influence new shareholders can exert through votes. Hence, suitable checks and balances must govern the founder’s actions. Rights like special investor approval for key decisions can balance founder control prerogatives with investor protections.

Read on for more perspectives

The above covers some key considerations regarding the choice of startup equity structure. However, optimal decisions account for context, including the stage of business, funding requirements, and objectives sought from new investors. 

Read on for additional perspectives on optimising your equity fundraising and ownership.

Startup stocks: Additional perspectives for founders  

1. Stage of business

Seed-stage companies should minimise preferential rights given to investors. Early investors assume the highest risks and should enjoy higher rewards via flexible instruments like convertible notes (debt that converts to equity in the next round). 

As companies mature, more complex multi-class stocks and protections become necessary to provide founders flexibility to raise growth capital while retaining control.

2. Funding requirement horizon 

The longer your business needs to stay private, the more control considerations apply in designing equity. For example, companies like SpaceX, expecting to stay private for 10+ years, issue special Class B shares, allowing founders to pursue long runways without interference.

If aiming for a short 2-3 year path to IPO, limited dual-class structures might suffice to protect near-term control before public listing scrutinises governance.   

3. Investor base mix

Investors have varying return objectives and abilities to add value. A smart move would be to align specific groups with incentive structures that match their metrics. This approach can have a longer-term mentoring orientation that is amenable to flexible notes. 

However, some investors need preferred stocks with exit preferences and ratchets for follow-ons. It is important to optimally align these investors to ensure they receive the rewards they expect.

4. Founder stock alternatives

Restricted stock awards for employees generally make sense early on to conserve the option pool without diluting founders excessively. Equity crowdfunding platforms now allow selling small common stock chunks to the public to raise startup capital without founder equity dilution. 

Conclusion

When starting a company, the way you divide up ownership between the founders and investors is really important. It’s up to the founders to decide what they want to achieve with the company and negotiate with investors to create a fair ownership structure. If this is done well, it can help the company grow and be successful over time. Understanding how this works can help founders make sure they create an ownership structure that helps, not hurts, their company as it grows.

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