As your start-up grows and evolves, through various funding rounds, it is likely that you will need to issue preferred shares at some stage. The timing and terms of these pref shares can have a huge impact on how much money you, as the technopreneur, actually make when finally exiting.

Unless you’re one of the lucky few who start and take a company public in an IPO, the other option for a successful “exit” from that business is to sell it. This exit opportunity is especially important for startups that raise venture capital.

Actually starting the business and attracting the first funding is hard, but the shareholding terms are usual quite simple, as the founders, employees and early (probably angel) investors usually get issued ordinary shares (common stock), all with equal rights. You are most likely to hear pref shares and “liquidation preferences” first being mentioned when you are raising capital in a Series A round, and attract the interest of institutional investors.

Let’s first discuss how pref shares normally operate:

Pref shares represent an equity ownership position in a company, yet they convey a series of additional rights that are “in preference” over those of ordinary shares, making the shares more valuable. One of the key rights that come with preferred shares is the liquidation preference, meaning that the preferred shares will have priority over common shares in a liquidation event (in this case an exit such as a sale, merger or change of control).

Except for price — valuation and investment amount — liquidation preferences are the most important deal term, since they set the rules for who gets what portion of the pie in a liquidity event. The liquidation preference determines what multiple of the original investment per share is returned to the investor before proceeds can be distributed to the holders of ordinary shares.

“Participation”determines whether the preferred shareholders participate in the division of the proceeds with the holders of common stock after their liquidation preference is returned. Fully participating holders will share the remaining proceeds with the ordinary shareholders. Non-participating holders won’t.

There can be different classes of pref shares, with later investors typically requiring preference (seniority) over earlier pref shares, given that they are usually making larger investments. Thus a Series C investor may determine a Series C pref share class which is paid before the Series B pref share class or the Series A pref share class. This stacking of pref share classes can get very complicated, very quickly.

Pref shares will no doubt become a fact of life if your startup successfully evolves through the various stages and funding rounds. VC’s are duty-bound to return capital back to their investors, and hopefully with more than they started with.

Your negotiation power,  based on supply and demand for investment into your company, and on the economic climate, will determine your ability to follow these basic rules regarding pref shares:

1. Hold out against them for as long as possible – once you introduce pref shares, subsequent investment rounds will want at least the same rights as previous investors, so there is no going back.
2. Negotiate for non-participating preferred stock, which is reasonably standard for technology start-ups. According to a recent quarterly report on venture deal terms from Cooley, a major Silicon Valley law firm, over 80 percent of the VC deals struck in Q2 2017 had no participation rights attached.
3. If the investors are to have participating preferred shares, then work on the liquidity preference multiple, which in this case should not be more than 1, to limit the “double dipping”.
4. It is usual to have a clause to cater for the situation where the proceeds from liquidation don’t cover what the preferences investors are entitled to, where these shareholders would convert their pref shares to ordinary shares, thus receiving a proportional share of the proceeds alongside other common stockholders.
5. Keep it simple by only having one class of pref shares across the various rounds. A complicated cap table can affect your ability to raise capital in further rounds and increase your risk of failure.

Recognising that a start-up needs capital to grow, technopreneurs should go into VC negotiations with their eyes open, in order to maximise their returns on exit, and to avoid the pitfalls along the way.