Should I implement a Dual-Class Common Stock Structure for my Startup?
February 3, 2022
A typical startup company authorizes one class of Common Stock, with simple rights. For example, each share of Common Stock is entitled to one vote on all matters subject to stockholder approval. However, a less common but growing trend is for startup founders to elect to implement a dual-class Common Stock structure for their companies, e.g., Class A Common Stock and Class B Common Stock. The structure was initially popularized following Facebook’s 2012 IPO. Essentially, the idea is that Class A shares mirror the typical Common Stock described above, with 1x voting rights (“low-vote”), while Class B shares have greater than 1x voting rights (“high-vote”), and, in some cases, other rights preferences and privileges. Generally, the thinking on these dual-class structures has been along the following lines: “High-vote shares are fine in the case of hot companies like Facebook, however, a high-vote/low-vote structure is not appropriate for most startup companies, and will not be acceptable to VCs, so you should not bother implementing this structure in the first place as you will ultimately need to unwind it.” However, we have worked with some startup companies where founders were able to maintain high-vote shares post Series A, with new investors purchasing Preferred Stock with 1x voting rights. Ultimately holding high-vote shares will allow founders to maintain control of their companies beyond an initial public offering (“IPO”), even in cases where several rounds of venture financing have caused significant dilution. At an IPO, when the outstanding Preferred Stock automatically converts to low-vote Common Stock, the founder-held high-vote Common Stock will likely shift voting control back to the founding team.
Founders should consider the most basic dual-class Common Stock structure if long-term voting control is an important issue to them. In this simple structure the high-vote class has 10x voting and the low-vote class has 1x voting, but otherwise the rights and obligations of the classes of Common Stock are identical. The high-vote shares could also have other features, like (i) automatic conversion to low-vote upon a transfer or sale to a third party, (ii) optional conversion to low-vote shares at the election of the holder, and (iii) protective provisions requiring approval of the holders of high-vote shares for certain corporate actions, like M&A.
How does a founder convince a lead Series A investor that it makes sense for the founder to keep high-vote shares, while the investor purchases preferred stock that is convertible into low-vote shares? Many VCs want to be perceived as “founder friendly” so they generally will not take the position that long-term control over the company by founders is a bad thing. Founders are the visionaries, after all. They will instead point to how they are being disadvantaged by having low-vote shares while founders have high-vote shares. But this is generally not the case as VCs will require a startup company agree to certain “protective provisions” in a term sheet and as a condition to the investment. Namely, VCs are going to require investor approval before a company can take certain actions like amending the certificate of incorporation, which is needed in order to raise a new financing round, or to effect a liquidation event like a M&A transaction. Both amending a certificate of incorporation and selling a company will require a stockholder vote under Delaware law, but here VCs will have an ability to block these transactions whether you have 10x, 100x or 1000x voting rights because only the holders of Preferred Stock can vote (i.e. as a separate class) on the matters covered by the protective provisions.
A founder may be wonder why bother with high-vote shares if having them will not help founders out-vote other shareholders on important matters like amending the charter or liquidating? It is really about long-term control, particularly following an IPO. Preferred Stock will convert to Common Stock upon an IPO, at which time investors lose the benefit of the protective provisions, which as discussed gives them blocking rights on significant corporate actions. After all the Preferred Stock has converted to low-vote Common Stock, the high-vote shares should easily outvote the low-vote shares, even if there are significantly more low-vote shares outstanding. The downside of implementing a dual class structure is low – you may need to unwind it and revert to a single class structure if the company has little negotiating leverage and needs to get a new financing done. But the upside of long-term voting control is high.