Understanding Founder Preferred Stock and Its Alternatives

Founder preferred stock is a unique type of equity that can be a crucial tool for startup founders looking to raise capital without giving up too much control.

As we'll explore, founder preferred stock can be a more flexible alternative to traditional venture capital funding, allowing founders to maintain a higher level of ownership and control over their company.

One key benefit of founder preferred stock is that it can provide a higher valuation for the company, allowing founders to receive more value for their shares.

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Founders preferred stock is a type of equity issued to founders of a startup company. It's a special type of stock that includes a conversion feature.

This feature allows the founder's preferred stock to be automatically converted into preferred stock under certain circumstances or transactions. Founders can sell their shares to investors without potentially triggering adverse tax consequences.

The main purpose of founders' preferred stock is to address specific tax considerations related to the sale of shares by founders. It ensures that the transaction is treated as a capital gain rather than ordinary income for the founders.

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Typically, founders' preferred stock comes with specific conditions and restrictions. It often includes provisions that allow for automatic conversion into the same class of preferred stock being sold in a new financing round, subject to approval by the company's board of directors.

Founders' preferred stock can be used to provide founders with an opportunity for early liquidity. However, some venture capitalists may prefer founders to maintain a long-term commitment to the company's success.

Issued to a founder, founders' preferred stock typically can only be converted to the round of preferred stock being sold at the time of a new financing and upon approval of the board. It can always be converted at the option of the founder into common stock.

Using founders' preferred stock can help reduce overall dilution and avoid unnecessarily inflating the company's 409A price used to establish the exercise price of the company's stock options.

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Founders' preferred stock is typically issued alongside common stock, with the common stock being subject to vesting. This means that founders will receive a mix of both types of stock.

Founders Preferred Stock must be fully vested at the time of issuance for tax reasons. This results in a more straightforward equity structure.

In some cases, investors may require that founders' preferred stock be removed or gutted, effectively making it equivalent to common stock.

Vesting Rules are crucial for founders to understand, especially when it comes to Founders Preferred Stock. Founders Preferred Stock must be fully vested at the time of issuance.

For tax reasons, this type of stock cannot be subject to forfeiture or repurchase. It's a common practice to issue a mix of Founders Preferred Stock and Common Stock, with the Common Stock being subject to vesting.

In many cases, the vesting period for Common Stock can be 4 years, with a 1-year cliff. This means that the founder will only vest 25% of their shares after 1 year, and then 25% every 6 months thereafter.

Class FF Stock is a type of equity that allows founders to get some early liquidity.

It's essentially common stock with a twist that allows it to be converted to preferred stock. Typically, it can only be converted to the round of preferred stock being sold at the time of a new financing and upon approval of the board.

Class FF Preferred Stock should be adopted at formation and represent only a small portion of the founder's stock, no more than 10 to 25 percent of the overall equity allocated to a founder.

For tax purposes, the stock needs to be granted fully vested. This is why we typically recommend no more than 10 to 25 percent of the overall equity allocated to a founder be Class FF.

Using Class FF Preferred Stock will help avoid unnecessarily inflating the company's 409A price used to establish the exercise price of the company's stock options.

This is beneficial as it helps to ensure the company's options remain an attractive tool to motivate the company's employees.

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Founder preferred stock offers a unique solution for founders seeking liquidity.

Compared to other paths to liquidity, purchasing common stock may not be desirable from an investor's perspective because it puts them at the bottom of the capital stack.

A secondary sale, where a founder sells shares to a third party or investors in connection with a financing, is not always possible or desirable because it can misalign a founder's interests with those of the company and its shareholders.

Purchasing common stock can also create issues, but founder preferred stock is designed to provide a more flexible and equitable solution for founders and investors alike.

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Class FF Preferred Stock can be a useful tool for founders to get some early liquidity, but it should be adopted at formation and represent only a small portion of the founder's stock.

Typically, no more than 10 to 25 percent of the overall equity allocated to a founder should be Class FF.

This is because, for tax purposes, the stock needs to be granted fully vested.

Using Class FF Preferred Stock can also help reduce overall dilution, as the total number of shares outstanding remains the same.

This is because the founder is selling their own stock and the investor is buying that same stock once it's converted into preferred stock.

As an added benefit, using Class FF Preferred Stock can help avoid unnecessarily inflating the company's 409A price.

This is important because it helps ensure the company's options remain an attractive tool to motivate employees.

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