Understanding Founder Roles and Types of Stocks


Founders are always confused about what it means to be Founders, Shareholders, Directors and Executives as well as what are the differences between Common stock and Preferred stock.

Let’s unpack how it all works!

1. Definitions: Shareholder

Shareholder - someone who owns a STOCK of SHARES of a company.

All Shareholders VOTE to elect the BOARD OF DIRECTORS.

2. Definitions: Common Stock

Common stock is an ordinary stock of a company.

Typically, each share corresponds to a single vote.

Typically, common stock doesn’t have many other rights - which is why it is called Common or Ordinary.

3. Definitions: Preferred Stock

Unlike Common Stock, Preferred Stock has additional rights.

Why?

Because Preferred Stock wants to exert control over the business that it otherwise could not via a simple vote.

That is - Preferred Stock is an overwrite for a vote!

4. Example

When the company starts, Founders hold 100% of stock - typically Common stock.

Say they raise pre-seed and sell 20% of the company to Angels and VCs.

Angels and VCs want Preferred shares - even though they have less share - 20% vs 80% they want Preferred stock because they want special rights.

5. Rights of Preferred Stock

There are MANY rights that Preferred Stock might have. Here are some examples:

  • Get Money Back aka Liquidation Preference

  • Convert to Common Stock

  • Appoint a Board Director or Observer

  • Maintain Pro-Rata in the next financing

  • Tag along and Drag Along

  • Anti0dilution

  • Multiple liquidation preferences - this is evil

  • Participating Preferred - this is evil

6. Should Investors Convert or Get the Money Back?

Say investor invests $1M at $5M post-money for 20% of the business.

1 year later founders gets an offer to sell for $2M.

Founder would make $1.6M or 80% of $2M and investor 20% of $2M or $400k.

That’s not fair to the investor.

7. Get the Money Back

This is why investors want a Liquidation Preference or an ability to get paid back BEFORE the founders.

In this example with 1x Liquidation Preference on $2M exit, investor would get their $1M back and the Founders would get the other $1M.

Now if the company was sold for $10M instead the investor would CHOOSE TO CONVERT TO COMMON STOCK.

Why?

Because 20% of $10M is $2M which is more advantageous than getting $1M back.

8. Conversion to Common

In general when company does well in M&A or IPO Preferred investors GIVE UP their rights and converts to Common.

Why?

Because at that point they ware willing to FOREGO their Preferred Rights in exchange for getting the MONEY!

9. Pro-rata right

Another typical right VCs want is ability to keep their % ownership in the next round - so called pro-rata right.

Why?

TL;DR - the math for most VC Funds forces then to care about pro-rata & ownership.

10. Anti-dilution

Another related right VCs ask for is to not be diluted by the founders.

How does that work?

Founders could issue more shares and give them to themselves or employees.

VCs don’t like that because they want to own specific % of the company, so they create a rule that no additional shares can be issued without their approval.

11. Definitions: Board of Directors

We next focus on 1 very specific piece of the puzzle - Board of Directors

The Board is elected by Shareholders and appoints the CEO.

CEO hires the executive team and runs the company.

12. Preferred Investors want Board Representation and sometimes - Control

This is key to understand - Board of Directors is an ultimate mechanism to control the business, and to know - what is going on.

That’s why VCs want board seats.

13. How Board of Directors Votes

A typical early board maybe 2 Founders + 1 Investor or 2 Common / 1 Preferred Seats.

Investors typically have approval rights on the annual budget, M&A, etc.

BUT in this setup, the investor can't fire / appoint new CEO.

Why?

Because boards VOTE and 1 Investor vote is < 2 Founders Votes.

14. Typical board compositions

Day 1 -- 2 Common - just the founders

Pre-seed / Seed -- 2 Common / 1 Preferred

Series A - 2 Common / 2 Preferred / 1 Independent

Series B - 2 Common / 3 Preferred / 2 Independent

Founders typically maintain control until Series B, but not beyond.

15. The job of a board is to appoint CEO

This is a critical point -- board appoints the CEO, who is an executive, who then hires the rest of the executive team.

So by appointing the CEO, board effectively controls the business.

16. Why are the founders so confused about this?!

Because Day 1 the Founders are:

  • Shareholders

  • The Board of Directors

  • The Executives Founders think of themselves as

And in fact, Founders DO NOT GOVERN OR HAVE ANY LEGAL RIGHTS.

Say, WHAT?!!

Let me explain.

17. Founders are the original shareholders

Founders say - this is MY COMPANY.

This is both true and false.

In the beginning founders have most equity and control, but over time they typically give up both and the Founder is a SYMBOLIC TITLE but has NO LEGAL STAND.

It is important to emphasize as I’ve heard this from many founders over the years - BUT I AM THE FOUNDER or CO-FOUNDER.

Believe me - I feel you.

But legal is legal.

Shareholders, Directors and Executives is all there is.

18. Understanding the Initial Setup

Day 0 I hear founders say - I am the CEO or CTO.

Legally what happens is:

  • They both are shareholders

  • They appoint themselves to the board of directors (typically unless they decide differently)

  • They as directors appoint the CEO who appoints the CTO.

Who does all this setup?

Your lawyers!!

Behind the scenes they use a bunch of legal documents to set it up properly, the way you want it.

If you don’t have a good lawyer - get one ASAP.

I’ve seen so much COSTLY MESS in startup docs!!

  • SUMMARY

  • Founders are original shareholders but aren’t a legal entity from company perspective

  • Day 1 founders are shareholders, directors and executives

  • Founders have common stock and sell preferred stock to investors

  • Investors want Preferred stock to exert control over the business event hough they don’t own as much

  • Board of Directors appoint the CEO who hires the rest of the executive team


As always, thank you for reading!

Alex

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