How to Calculate the Price of Preferred Stock for a Startup

by Jennifer Kiesewetter in
three women sitting beside table

TLDR

  • Companies often issue both common and preferred stock to reward those putting in sweat equity and those investing. Understanding which shares to issue to whom is a critical decision for startup founders.
  • Stock, or equity, is often one of the most critical assets for a startup. Equity can help a startup attract top talent as well as investors.
  • In a new business, two types of stock are typically offered: common and preferred.
  • Although preferred stock also represents ownership, it differs from common stock in two significant ways: no voting rights and preferential claims.
  • Common stock is typically issued to employees, strategic advisors, and founders because of the differences between common and preferred stock. Preferred stock is generally reserved for investors.
  • Seed stage funding is the first initial stage of funding for a startup. Often, the seed stage consists of investments from family and friends. This early investment round helps a startup prove itself, creating a track record of growth.
  • Early in a startup’s existence, investors often like to make their investment into a distinct type of shares called “series seed preferred shares.”
  • Convertible preferred stock is a type of stock giving holders the ability to convert their preferred shares into a set number of common shares after a specified date. The ability to convert preferred shares to common shares can financially benefit the stockholder.
  • Here’s an easy formula for calculating the value of preferred stock: Cost of Preferred Stock = Preferred Stock Dividend (D) / Preferred Stock Price (P).
  • Par value of one share of preferred stock equals the amount upon which the dividend is calculated. In other words, par value is the face value of one share of stock.
  • Cumulative preferred stock is preferred stock, which pays cumulative dividends if a dividend payment was missed.
  • Suppose a dividend payment on preferred stock was missed in the past, for whatever reason. In that case, the cumulative amount of dividends must be paid to the preferred stockholder first before any other stockholder gets paid.

An endless to-do list exists for startup founders. From finalizing your product to establishing your proof of concept to securing financing, founders have a dizzying number of hoops to jump through.

One critical hoop includes issuing stock in the startup to founders, employees, and investors. Companies often give both common and preferred stock to reward those putting in sweat equity at the early stages of the business as well as those taking the risk to invest. Understanding which shares to issue to whom is a critical decision for startup founders.

In this article, we’re going to explore the differences between common and preferred stock as well as how to calculate the price of preferred stock.

What is Startup Preferred Stock?

Stock, or equity, is often one of the most critical assets in a startup. Equity can help a startup attract top talent as well as early-stage investors. In a new business, two types of stock are typically offered: common and preferred. Common stock is a share of ownership in the startup, typically accompanied by voting rights. Although preferred stock also represents ownership, it differs from common stock in two significant ways: no voting rights and preferential claims.

Preferred stock typically does not come with voting rights, like common stock. Additionally, preferred stockholders receive payment of dividends before holders of common stock. Preferred stockholders also hold claims to the startup’s earnings and assets over common stockholders. In other words, if there is a payout from the startup, preferred stockholders receive it before common stockholders. Other preferential treatment includes liquidation preferences, right of first refusal, and redemption rights.

In most startups, common stock is issued to employees, strategic advisors, and the founders. Preferred stock is generally reserved for investors.

What is the Difference Between Common Stock and Preferred Stock?

As stated above, a common stock owner has purchased ownership in the startup along with voting rights, enabling them to vote on issues such as who will serve on the board of directors or on specific management decisions. The more ownership you have, the more significant impact your vote holds.

Preferred stock, on the other hand, includes preferential treatment over common shares. Here are the significant differences between common and preferred stock:

  • Voting rights: Typically, common stockholders have voting rights and preferred stockholders do not, even though both stockholders are owners in the startup.
  • Dividends: Both common stockholders and preferred stockholders can receive dividends. However, preferred stockholders typically have access to guaranteed, fixed dividends instead of dividends based upon the startup's profitability.
  • Returns: Both common stockholders and preferred stockholders are paid out of the startup’s earnings. However, returns for preferred shareholders are based on mandatory dividends where common stockholders receive returns based on the increase or decrease of the stock’s price.
  • Claims to Earnings: Unlike common stockholders, preferred stockholders are paid out first where common stockholders are paid out last.

Common stock is typically issued to employees, strategic advisors, and the founders because of the differences between common and preferred stock. On the other hand, preferred stock is generally reserved for investors. Because preferred stock creates a more advantageous position for investors as it mitigates their investment risk by giving them a greater claim to the startup's assets. Investors today typically will not invest in your startup in exchange for common share ownership. They insist on preferred shares.

What is Series Seed Preferred Stock?

When you have a startup, you face different stages of fundraising. For example, when you are fundraising for the first time, you are often in your “seed” stage. Seed stage funding is the first initial stage of funding for a startup. Usually, the seed stage consists of investments from family and friends. This early investment round helps a startup prove itself, creating a track record of growth.

Early in a startup’s existence, investors often like to make their investment into a distinct type of shares called “series seed preferred shares,” According to the National Law Review:

"The seed funding instrument that most closely mirrors that used in a traditional capital financing is Series Seed Preferred Stock. Just like investors in a venture capital financing, investors in a series seed financing purchase, at a negotiated price, receive preferred stock with a liquidation preference and other negotiated special rights. As a result, and unlike holders of convertible promissory notes or SAFEs, series seed investors become stockholders of the company who benefit from the voting and other rights provided to stockholders under state corporate law.

These shares 'differ from ordinary shares because they give the investor greater upside potential and a level of downside protection in return for their investment.'"

Essentially, “series seed financings differ from venture capital financings in that the special negotiated rights attached to the preferred stock sold are usually scaled back, and the documentation involved is condensed into fewer agreements.” These distinctions are important for founders to understand and use to their advantage when funding their startup.

What is Convertible Preferred Stock?

Convertible preferred stock is a type of stock giving holders the ability to convert their preferred shares into a set number of common shares after a specified date. The ability to convert preferred shares to common shares can financially benefit the stockholder.

For example, if the price of common shares increases, the stockholder can sell their preferred stock for common stock, receiving multiple common shares for one share of preferred stock. If a startup has a conversion rate of 10, then a stockholder can receive ten shares of common stock for each share of preferred stock. Thus, when preferred stockholders convert their stock to common stock, they participate in the startup's growth.

How Do You Calculate the Cost of Preferred Stock?

Calculating the price for a startup's preferred stock is often difficult as the business is new, without a track record of sales or other financial indicators of success. However, early startups' preferred stock can be priced. Let’s see how.

According to Corporate Finance Institute, “[t]he cost of preferred stock to a company is effectively the price it pays in return for the income it gets from issuing and selling the stock. In other words, it’s the amount of money the company pays out in a year, divided by the lump sum they got from issuing the stock.”

Here’s an easy formula for calculating the value of preferred stock:

Cost of Preferred Stock = Preferred Stock Dividend (D) / Preferred Stock Price (P)

Here’s an example:

A startup has preferred stock that has an annual dividend of $3. If the current stock price is $25, what is the cost of preferred stock?

Cost of Preferred Stock = D / P0

Cost of Preferred Stock = 3 / 25 = 12%

Startup management must keep the following in mind when offering preferred stock. 

  • Preferred stock “has the benefit of not diluting the ownership stake of common shareholders, as preferred shares do not hold the same voting rights that common shares do.”
  • Preferred stock lies “in between common equity and debt instruments, in terms of flexibility.”

How to Calculate Par Value of Preferred Stock?

Par value of one share of preferred stock equals the amount upon which the dividend is calculated. In other words, par value is the face value of one share of stock.

Here’s an easy equation to determine the par value of your preferred stock:

Preferred Stock Par Value = Number of preferred shares issued x par value per share

For example, if the preferred stock's par value is $2,000 and the dividend in 5 percent, then the startup must pay $100 annually for as long as the preferred stock is outstanding. On a balance sheet, a startup reports the par value of common stock and preferred stock separately.

How to Calculate Cumulative Preferred Stock?

Cumulative preferred stock is preferred stock, which pays cumulative dividends if a dividend payment was missed. A cumulative dividend is “a required fixed distribution of earnings made to shareholders.” Preferred shares are the most common stock class providing a right to receive cumulative dividends.

Suppose a dividend payment on preferred stock was missed in the past, for whatever reason. In that case, the cumulative amount of dividends must be paid to the preferred stockholder first, before any other stockholder gets paid.

Benefits

It’s essential to objectively establish your business's value as a startup, which directly impacts your preferred stock price. By establishing these figures early in your business venture, you can show your business's value to potential investors, which is instrumental to growing your startup. Since investors want to accept more favorable stock ownership terms, understanding your startup's value is critical to your startup’s growth.

Limitations

As a new company, it’s often difficult to establish a startup valuation as no concrete data exists about annual sales, profits, expenses, and taxes. With startups, the valuation numbers can change based on varying forecasts, estimates, supply and demand, economic and industry-specific factors, and other unknowns, often making valuation and preferred stock pricing a moving target.

However, as you move forward with your startup, although preferred stock is often preferred by investors, do understand that preferred stock can be quite expensive. Further, investors with preferred shares do not enjoy any voting rights. Thus, these investors cannot influence the management or growth of the startup moving forward.

We can help!

At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most — your business. If you're looking for help establishing equity rounds for your startup, we can get your documentation ready, overall shepherding this process to ensure it's done right. Sign up for early access to get started.

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Note: Our content is for general information purposes only. AbstractOps does not provide legal, accounting, or certified expert advice. Consult a lawyer, CPA, or other professional for such services.

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