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
