Are Special Classes of Founder Stock Right for You?
October 22, 2015 posted by Bryce Counts
There is a tried and true structure for capitalizing a technology startup: conventional common stock to the founders, conventional common stock reserved for employees in a stock option pool, and preferred stock to investors. However, over the last decade, a number of startup accelerators and their law firms have developed special classes of securities such as “Class F Common Stock” developed by the Founder Institute, or “Series FF Stock” developed by Founders Fund. Additionally, over the years the press has given significant coverage to Mark Zuckerberg, the Google founders, and others who have managed to maintain voting control of their companies while selling majority ownership to their investors via the use of classes of stock with special voting and economic rights. This leads many entrepreneurs to question whether they should include such structures in their own technology startups.
Class F Common Stock
Class F Common Stock was developed by the Founder Institute to give founders voting control over their startups. The “F” stands for “Founder” but you can call the stock whatever you want. The key feature of Class F Common Stock is its voting rights. As opposed to conventional common stock, which carries only one vote per share, Class F Common Stock carries 10 votes per share (thus, a shareholder with 10 shares of Class F Common Stock will have 100 votes at a shareholders’ meeting, and a shareholder with 10 shares of conventional common stock will have just 10 votes). Class F Common Stock might also contain veto rights over certain corporate transactions such as amendments to the company’s charter, the authorization of additional shares of Class F Common Stock, and change of control transactions. Finally, Class F Common Stock typically also contains special board voting rights, usually allowing the holders of the Class F Common Stock to designate a member to the board of directors who gets two votes on any matter.
Series FF Stock
Series FF Stock has a name that is very similar to that of Class F Common Stock, but its purposes are quite different. Whereas Class F Common Stock is about control, Series FF Stock is about economics – the founders’ economics. Series FF Stock is generally identical to conventional common stock, except that Series FF Stock can be converted, at the option of the holder, into a series of preferred stock which is then sold to investors. Typically this conversion occurs just prior to a financing, with the investors in the financing buying a portion of their shares of preferred stock from the company, and a portion of their preferred stock from the founders, via the Series FF Stock that is newly converted into preferred stock. The effect of this is to give the founders an opportunity to get some liquidity by taking a little bit of the money from the financing off the table.
Class F Common Stock and Series FF Stock can take many names and many forms, and in some cases, the concepts from the two might be blended. But the idea is that these are special classes of stock that give the founders voting and/or liquidation rights that are atypical for most startups.
Should you Utilize Special Classes of Founder Stock?
At first glance, many founders think that having a special class of stock that grants super voting rights or liquidity at a financing seems like a no-brainer. Who wouldn’t want to maintain control and/or take a little cash off the table at financing? However, most investors in early-stage technology startups have not gotten on board with these concepts, and in the cases where they have, there have typically been special circumstances warranting the unique stock classes, or the founding team and/or the company were so white hot that they had an abnormal amount of bargaining power with their investors.
With respect to early liquidity, most investors want their founders to be hungry – both in the literal and figurative sense. Investors in early-stage startups are taking huge risk on their investment, and they want the founders of the companies in which they invest to be “all in” and working as hard as they possibly can to turn their little startup into a multi-million (or billion) dollar home run. Many investors fear that if the founders take a little liquidity at a financing event it will disincentivize them to chug away as hard (and it can also signal that the founders are just looking for a quick payday, and don’t truly believe the startup has legs).
As far as control issues are concerned, investors typically want to have a voice when it comes to decisions that can dilute them or have a material impact on the business. This is why it is customary for investors to negotiate certain voting rights (or protective provisions), that give investors veto rights over certain enumerated company actions or transactions. In most cases, a class of founder stock that eliminates or severely reduces these veto rights will run contrary to this fundamental principal of startup investment.
Unless there are very good reasons for investors to go along with these special classes of stock, they will typically require that they be pared back or completely eliminated as a condition to their investment. If this happens, not only would the time and cost spent on putting these classes of stock in place have been wasted, but the founders will have to pay again to have their company’s capitalization put back into a more traditional structure before they’ll receive any investment dollars – an unfortunate double-whammy. Thus, special classes of stock providing founders special voting rights or early liquidity should be used with caution, and in the vast majority of cases, should be avoided altogether.