Posted: April 16th, 2014
The following post was written by guest blogger and CLBC student Dan Waxman (JD ’14).
When forming a start-up venture, an entrepreneur must decide which form of legal entity best suits the business’s needs. For example, an individual forming a small, family-run business may decide to form a limited liability company (“LLC”) due to its favorable tax treatment and relatively few formalities. However, should the business require venture capital (“VC”) funding, the corporate form is likely the best option, as VC investors generally refrain from investing in LLCs and other non-corporate entities.
Once a corporation is formed, an issue arises concerning the distribution of ownership interest in the corporation. For example: How many shares should the corporation authorize? Should it authorize preferred shares? If so, what are the terms of the preferred shares? Will potential investors agree to pre-set terms?
The good news is that many of these questions can be postponed until more information is obtained from potential investors. For example, a corporation can always authorize more shares with the approval of a majority of its board of directors and shareholders. Therefore, a sole owner can (while following certain formalities) file a share authorization form with the secretary of state should a VC investor require a greater number of authorized shares.
Furthermore, VC investors generally prefer to purchase preferred (as opposed to common) stock in a startup. This is because the investors have more leeway concerning the rights granted by preferred stock relative to common. The question then becomes which rights should the stock contain and which will the investors prefer? Such questions generally remain unresolved until the investment negotiation process.
Therefore, corporate law allows the corporation to authorize “blank check preferred” stock. Essentially, the stock is authorized without set terms. This allows corporate agents to negotiate with potential investors while using the characteristics of the preferred stock (dividend rights, participation, liquidation preference, convertability, voting rights, etc.) as bargaining leverage. It also allows the corporation to easily create new classes of preferred stock. Once the parties have settled on a mutually agreeable term structure, corporate management can issue preferred stock (from the pool of unissued blank check preferred shares) containing the agreed-upon rights without having to re-authorize additional shares.
Therefore, when forming a corporation in anticipation of VC investment, authorizing blank check preferred stock in addition to the corporation’s common stock can ease concerns over the proper composition of the preferred stock and facilitate investment negotiations.