Preferred Stock

When a company is established, the founders and staff take common stock equity. When investors take equity, it is in the form of preferred stock which means that it is paid out before (in preference to) common stock in the case of a liquidation.

If at the point of exit the valuation dips (for example the company doesn’t perform as expected and is sold for less than the valuation at the last investment round) then the preferred shares are redeemed at their purchase value before the common-stock holders share the remainder.

Founders can cap the return of preferred stock to limit the up-side (and preferred stock may have a fixed return rather than a share in the future value), but investors have the option to convert preferred stock to common stock by surrendering the preference rights (in a one-way transaction, as common stock cannot be converted to preferred stock).

If you’ve got this far into the term sheet arrangements, congratulations – you probably now need some specialist help to get those agreements right, a self-help guide won’t be sufficient.