SUB CATEGORIES OF Funding Your Startup

A preferred stock purchase agreement is exactly as it sounds; it is an agreement to purchase stock, specifically preferred stock. Of course, that doesn’t necessarily explain very much. To understand what the document itself is and exactly how it operates, we should start with a definition of “preferred stock” shares themselves, which are really just shares that provide owners of those shares with special privileges relative to common stock owners. For example, preferred stock may pay out a higher dividend per share than does common stock or alternatively, pay out a dividend regardless of corporate earnings. Preferred shares may be less susceptible to dilution, and may possess a debt as well as an equity component. Furthermore, preferred shares will sometimes be “convertible,” i.e. come with an option to convert those shares into common stock shares at a particular ratio of common to preferred.

Given this vast potential for customization in the creation of preferred shares, it is important to clearly delineate the terms of the stock transfer in the preferred stock purchase agreement, and dividend payments, convertibility, dilatability, and debt/equity hybridity are just the tip of the iceberg. Both parties to the agreement must make the necessary representations and warranties, including most notably their right to actually buy or sell the shares at issue as per the terms of both party’s Certificate of Incorporation, corporate bylaws, or any other applicable rule or requirement with which a party would ordinarily need to comply. Furthermore, both parties must ensure and protect against non-compliance with other agreements into which either side may have already entered. Thus, there are a lot of issues to consider, a lot of due diligence to be performed, and generally a lot to think about when entering into this sort of agreement.

That said, the good news is that a startup may not have nearly as many issues to grapple with as larger, more well-established companies. Startups are simpler in terms of their organization, they likely have signed fewer contracts obligate them in various ways, and they may be more nimble as a result. Nevertheless, consideration of these issues is paramount when entering into a preferred stock purchase agreement, and the goal of spotting as many potential issues as possible should be paramount in the minds of those parties to the agreement.