Angel investors provide financial capital to entrepreneurs and small businesses in exchange for an ownership state in the company or shares. These investors give money in the first stages of fundraising to support a growing company. They often want preferred shares or ownership that provides them with additional rights and to help minimize the risk.
While preferred shares are not required by all angel investors and funding deals, these investors primarily and sometimes exclusively exchange financing for preferred shares. The preferred stock will give them more financial benefits as shareholders, including a greater opportunity for profits through Quality dividends, which provide high-quality stocks, and preference in liquidation.
As an angel investor, you should be clear about your investment – it is important to understand what you are investing in. You can negotiate additional rights as a part of your investment and those rights end up as preferred equity.
As an entrepreneur or business, giving angel investors preferred stocks may be more expensive upfront but offer important benefits. Understanding the details of preferred shares will help to determine if and how you want to use these assets.
What are Preferred Shares vs. Common Stock?
Let’s look at the different types of shares in a little more detail to better understand why each of these equity stakes is important for a company’s growth. The exact terms and rate of a preferred share will be set when the angel investors and business owners are negotiating the company valuation and financial terms of the investment (Source: Univ. of Maryland Business).
As their name states, preferred shares (or stocks) are given preference over common stock. This is most apparent in the payout of dividends. For nearly all preferred stock agreements, the angel investor will receive a dividend that must be paid out before any money is paid to common shareholders (Source: Investopedia). This provides security and returns for investors.
The type of preferred share an angel investor holds will set by the investor and company. There are multiple types of preferred shares that can be issued to an investor:
- Cumulative preferred stock: This category of preferred stock requires that all dividends be paid in full to the investor, regardless of the company decided not to pay out dividends in the expected period. Depending on the terms, there may be additional benefits regarding interest payments on missed dividend payments (Source: Accounting for Management).
- Noncumulative preferred stock: Preferred stockholders will not be issued any dividends that were unpaid or put back into the company. Angel investors will still have preference for the issued dividends but have no rights regarding unpaid ones.
- Participating preferred stock: In addition to the dividend payment issued to the preferred shareholder, they will also receive an additional dividend that has been set at a predetermined rate. Receiving the additional dividend will depend on the value that is issued to the common shareholders. Specifically, when a company is sold, the investor will receive the value they put in, plus dividends and additional profits if available (Source: Founders Workbench). Nonparticipating preferred stock offers a return but doesn’t guarantee both dividends and additional profits (typically one or the other).
- Convertible preferred stock: This stock option allows preferred shares to be converted into common stock. This is typically done when the company is performing well and their stock price is increasing. Investors can then sell their shares at a profit or at least have the option to (Source: UpCounsel). The date and number of common shares issued are arranged in the negotiating phase.
Differences Between Stock Options
The primary difference between the options in shares listed above and common stock is the preference when it comes to dividends and finances, as well as the voting rights of shareholders.
Voting rights include choosing boards of directors, leadership decisions, and access to company decisions and meetings. One share allows for one vote, meaning larger shareholders have more rights (Source: Science Direct).
- Preferred shares will always have the financial upper hand, being paid first for dividends and above common shareholders in liquidation of assets given bankruptcy or sale. Preferred shareholders do not have voting rights within the company.
- Common stock is purchased in exchange for an equity stake in a company and voting rights. Common stock offers plenty of upside in long-term financial gains but does pose a risk in liquidation. Assets will only be paid out to common shareholders if there is money left over after paying out bondholders, preferred shareholders, and other debts (Source: Investopedia). This is risky in the event of bankruptcy and may deter angel investors.
Why Do Angel Investors Want Preferred Shares?
The different preferred shares compared to common stock provide us with great examples for why an angel investor wants preferred shares. While preferred shares do not typically provide financial growth opportunities like common stock does, they are far less risky, especially in the early stages of the company.
Because angel investors typically provide funding for companies when they are new, there is a larger risk they take on, not knowing how the company will perform. Being given preferred stock makes it easier for these investors to sleep at night, knowing their investment will yield dividend returns and they are in a better position to make their money back in case of liquidation.
Investors who want preferred shares are typically more risk-averse and want to protect their investment. The primary reasons that preferred shares are chosen by angel investors is because they provide:
- Stable cash flow: Especially for deals guaranteeing dividends (even missed ones), the consistent stream of cash flow and return on their investment is attractive (Source: Corporate Finance Institute). Once the investor’s initial investment is returned, they will benefit from future profits. Not only are these investors given dividends, but they are more likely to see these payments more frequently than common shareholders (Source: Houston Chronicle).
- Ownership value: Because preferred shares are equity in the company, the performance of the firm will change the preferred stock price. This allows for growth opportunities when the company performs well. This is different debt investors whose rates are dictated by interest rates.
- Preference in liquidation: Of course the company and angel investor do not want to see the company go under, but investors are protected in the event of a liquidation. They are right behind bondholders and debtholders when it comes to being issued assets and refunded their investment. Worst case, there are not enough assets to do so, but this is uncommon and most risk is placed on common shareholders.
Smaller businesses rely on angel investors for financing their companies and allowing them to grow. Because angel investors are individuals and not protected by large institutions, they want preferred stock to help them eliminate risk and feel more confident in their investment regardless of outcome.
Giving Angel Investors Preferred Stocks
Compared to common stock, it is more expensive for a company to issue preferred stock to an investor. Companies do so because they need access to the funding that these angel investors can provide. While it may be more expensive, a company is able to gain access to funding they wouldn’t get otherwise and still maintain their voting rights.
When you issue common stock to an angel investor in large amounts, they have voting power and could influence company decisions. To protect control over a company, preferred stock may be the best strategy. Most of all, companies issue preferred stock because angel investors want it. In order to receive funding to build a business, companies must adhere to investor needs.
The angel investor and company must work together to determine if issuing preferred shares makes sense for both parties and which shares will promote and protect the best interests of both parties.