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Tax Time Alert: Key Things to Know About Founders Preferred Stock

Opinion

Xconomy Boston — 

As you gather and review tax papers for your return, be sure to inform your accountant if you hold founders’ preferred stock, or if you sold a block of it in 2014.

Your CPA might not think to ask you about this because so few entrepreneurs hold this class of stock. As recently as 20 years ago, founders’ preferred stock (FPS) didn’t even exist. Lawyers for hot startups in high demand “invented” it to give founders a vehicle to pocket some cash by selling some of their equity in their wildly successful companies before they went public. That’s the type of transaction you need to share with your CPA now.

Many founders have heard about founders’ preferred stock, but fewer than 5 percent of companies that launch today have issued FPS to their founders. Those who do have it typically take a small portion of their equity holdings—less than 20 percent—in FPS. (The balance is common stock.) Nevertheless, all founders should understand its pros and cons so they can decide whether it’s worth fighting for.

FPS is, for all practical purposes, common stock with special conversion rights. It functions like ordinary founders’ common stock until it’s purchased by investors who are also buying preferred stock directly from the company. At that point of purchase, it converts automatically into preferred stock. Under any other conditions—a sale to any other purchaser in any other circumstance—it reverts, like Cinderella at midnight, back to common stock. It also reverts to common stock if the company is acquired or goes public.

Some founders like holding FPS because they can sell a few shares when the company is raising money in a preferred stock financing: they further dilute their ownership stake, but they get to pocket the cash themselves rather than having it go to the company the way the proceeds from the sale of other preferred stock do. FPS therefore gives them the option to pull capital from their startup without a liquidity event like a merger or public offering. They can bypass some tax-related headaches, too: When an investor buys FPS as part of a preferred stock financing, FPS converts to the preferred stock with few of the tax and accounting complexities that arise in repurchase, buyback, or exchange transactions with a founder.

Investors may be willing to buy FPS if it’s the only way to get a bigger piece of a hot company. But they are more likely to be leery of startups where founders hold this special stock. Some view the founders’ insistence on FPS as a warning sign that that leadership is hedging its bets. Instead of being fanatical about growing their business, they’re already contemplating how to secure a payout. A founder holding FPS can also make an otherwise straightforward deal more complex than it needs to be. Securing funding is a challenge even under the best of circumstances. Why make it easier for prospective investors to turn you down?

Not all founders want FPS, despite its cachet in some circles. They might not need the cash thanks to a successful exit or two already under their belts. They may not want to spend the time and money to hammer out the relevant clauses when they’re incorporating their company. Or they might have no plan to sell any part of their company until a major liquidity event. Sometimes legal questions have easy, straightforward answers. More often, they don’t. This is one of those cases. If you’re weighing whether FPS makes sense for your business and your future, think through these questions and then discuss them with a trusted legal advisor:

  • What is my vision for this startup? Am I planning to sell it in a few years for a few million dollars and then move on to something else? Or do I want the option of accessing cash during the long haul?
  • Will I want or need to extract money from my startup? Do I have some major expenses coming up—such as buying a house or paying tuition—that will require ready cash? Or do I have assets I can more easily tap?
  • Are investors likely to buy my FPS? Would they rather put their money back into my company than allow me to pull out cash for my personal use?
  • What tax burden will I face when I sell my shares? That’s a question you absolutely should ask your CPA or financial planner.