By Fernando Berrocal

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After forming a business, most entrepreneurs' initial thoughts relate to who gets what percentage. One frequent discussion concerns how exactly to divide stock. When launching a firm, you don't set aside or allocate any stock for investors–regardless of how much funds you need.  Contradictory as it may seem,  your investor shares are virtually always formed during a priced round fundraising event.

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This type of round occurs when a primary investor - employing a term sheet - commits to investment terms with a firm, and invests with other follow-on investors to buy preferred stock directly from the business.

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So, what’s the difference between common and preferred stock? When investors engage in an outside firm, they are taking a high risk.  They tend to want a specific safeguard. Voting rights and right of first refusal (ROFR) are some typical kinds of safeguards packaged into a preferred class of stock. Common anti-dilution measures include down round (or "ratchet”) precautions, as well as electing to participate in a liquidation (preferred shares are non-participating "by default”.)

Both types of stock classes - common stock and preferred stock - provide ownership in a new business. A single share's percentage ownership is equal to 1 divided by the total number of shares (both common and preferred) issued by the business. The term "completely diluted ownership" is also used. This comprises the number of shares in an option pool that is distributed to determine ownership.

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Can it be possible to have multiple classes of common stock? Multiple classes of common stock are used by startups, even though they are unusual (and generally aren't the best option). Sometimes this practice is implemented to limit the voting rights of one class of common stock (for instance, limit the voting rights of stock plan participants such as employees and advisors.) In concept, this may allow a founder or a group of them to keep control of the firm for longer than they could otherwise. If the founders find themselves struggling with investors over employee votes and are unable to shift employee opinion, there are likely to be broader concerns at hand; founder control isn't the main concern.

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What about multiple classes of preferred stock? In a word: no. A startup would never have more than one preferred stock class. That said, more developed startups will nearly always have many preferred stock series (all in the same class). So, we've already established that common and preferred stock belong to separate "classes–what about when you have different investors at different times? In this situation, Instead of numerous classes, you'd have various "series" of preferred stock.

You've likely heard of Series A, B, and so on. Each series of preferred stock refers to a different stock offering or a time when the business sells stock to investors privately. Each series of preferred stock can have its own sets of terms, such as a distinct preference multiple or a dividend declaration.  Bear in mind, however, that the series will inherit all of the preferred classes’ other rights and terms. A “Series A III” or similar nomenclature may also be mentioned;  this is what is known as a "shadow series". The name differentiates it from a conventional series.  All shadow series are similar (except for their sale price).

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What else is there to know about  a shadow series? This is a preferred stock series - identical to others - except for the issue price. This is most typically encountered while converting items such as SAFEs or convertible notes. After that initial round, a firm that raises three SAFEs at three different caps and discounts and then raises a series seed round will have four separate series of preferred stock: Series Seed-1, Seed-2, Seed-3, and Seed-4. The person preparing the paperwork decides which series is which; however, Series Seed-1 is typically the newly raised equity (at the greatest price per share). The various SAFEs transform at reduced values per share, with Seed-4 being the cheapest.

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What's a preference stack? Stockholders receive a preferred payout in the case of a liquidity event, such as a public offering, merger, or bankruptcy. The term "stack" comes from the fact that the principal investors get paid first, followed by the common stockholders. In most instances, the most recent cash invested will take the top spot; although it is technically something that is negotiated before each round of fundraising. Distinct preferred series of stock will be in pari passu; they all hold an equal place in the stack, and are classified as a single class when it comes to liquidation calculations. This is a different technique, yet one employed almost as frequently by startups.

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How does investor equity impact founder equity?  Businesses offer stock to investors to help the organization grow financially and expand their competencies. These shares are sold straight to the corporation for a profit. During fundraising, founders don't sell their shares to investors (except in special cases). When a firm issues a larger number of shares, the ownership of each share reduces. This means that current shareholders are diluted in the majority of situations–unless they buy more shares to maintain their percentage.

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What is dilution? It's the result of a business raising capital by issuing additional shares. When the total number of shares is increased, the proportion of the corporation represented by each share decreases. Though a founder's (or current shareholder's) portion of the business may be decreased in a fundraising round, the value of their ownership in the company doesn't. Since new investors are contributing capital, the firm's entire value grows by the same amount.

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Is it feasible for founders to avoid dilution and anti-dilution? When founders raise money from investors through a series of preferred fundraising, dilution cannot be prevented.  Preferred holders have anti-dilution protection in the form of "ratchet" clauses, but any anti-dilution for common investors normally expires when funding is raised.  Any anti-dilution provisions in place for a firm's shareholders can make it harder for the business to raise capital, worsen founder results, and - in certain cases - make fundraising functionally impossible.

You should expect a dilution of 10-20% every round. Thus, if you and your founding team own 100% of the business at incorporation, raise angel rounds, seed rounds, and Series A, B, C (before departing), you may expect to own between 32-59% at departure.

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Ready to bring your startup to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page.

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