Empire-building requires preferred investor protection

Many entrepreneurs dream of the day when an investor will infuse the venture with much-needed cash, either to get started or to grow the business. One of the most common forms of investment vehicles is for the entrepreneur's company to sell preferred equity to investors.

First, a quick primer. To keep things simple, let's agree that there are two kinds of equity or stock in a corporation: common and preferred. Common stock is simply a share of ownership in the company with few if any special privileges. Preferred stock carries with it unique preferences above and beyond the privileges of common stock holders.

Paul Allen, the founder of companies such as Infobases, MyFamily (now Generations Network), and now World Vital Records, often says that the most startling day of his business career was when he learned the difference between preferred and common stock.

Why would that be so earth-shaking? Well, how about waking up one day to find that your company sells for millions of dollars but you, the founder, get nothing.

Can that really happen? Yes, it can. And it does.

Preferred stock is what venture capitalists and seasoned angel investors will generally purchase when they buy straight equity in your company. The normal procedure is that you will either open a round of investment selling preferred stock or the investors will present you with a term sheet for putting together a preferred stock purchase agreement.

Preferred stock has preferences in certain situations and events. There are more than 30 distinct points of preferential treatments that can be given preferred stock. I am going to focus on what I consider the most important preferences, with details that are negotiable. There are many others that are standard inclusions and are usually not negotiable.

Liquidation preference — This gives the preferred stock holder an advantage in the case of liquidation, either for a good reason (lucrative sale) or bad outcome (insolvency). In other words, preferred stock holders get their money back before common shareholders. The customary preference is "one times" (1X) to "two times" (2X) the initial investment. For instance, if the investor put in $100,000 and the liquidation preference were 1X, then he would get his $100,000 back before any common shareholder (usually founders, employees, friends and family) gets one nickel. Now do you see why Mr. Allen was so startled? The company can sell for a tidy sum, but the founders get nothing. This situation is exacerbated if the liquidation preference is higher, such as 2X. In this case, it means if the company sold, the investor would get the first $200,000 of the proceeds. I have seen liquidation preferences as high as 5X.