“Ask the Attorney” – Series FF Stock

by Scott Edward Walker on April 21st, 2010

Introduction

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  Below is a longer, more comprehensive version.  Please give me your input in the comments section.  Many thanks, Scott

Question

I’m launching a new venture and read your VentureBeat post a few weeks ago about Class F stock.  I’m a little confused because I asked around, and none of my friends who are founders heard of it.  One guy did mention Series FF stock, but I wasn’t sure if that’s the same as Class F?  Please let me know.

Answer 

Yes, it’s definitely confusing — but “Class F” stock and “Series FF” stock are different.

As I previously discussed, Class F stock is a separate class of common stock that was designed in 2009 by The Founder Institute to provide the founders with certain special rights (e.g., super-voting rights) upon incorporation.  The articulated goal is to level the playing field for founders in connection with their negotiations with investors and to protect them from the “atrocities of investors.”   

Series FF stock, on the other hand, is a separate class of preferred (not common) stock that was designed in 2006 by Sean Parker of the Founders Fund to permit founders to cash out a small percentage of their stock prior to a liquidation event. (The “FF” stands for Founders Fund, and it has been used in several Founders Fund deals.)

Indeed, as Barney Pell, the founder of Powerset, noted in the San Francisco Chronicle:

“There is often a tension between venture capitalists and founders. The venture capitalist wants the founders to starve and to have no cash liquidity until the very end. Of course, the founders, unlike the venture capitalists, are putting all of their eggs in one basket…. Sean came up with the idea of allowing founders to sell small amounts of their shares along the way so you can have some life-changing effects and reduce your risk and everyone can be aligned for a home run.”

Here’s how Series FF preferred stock works:

1)      Shares of the Series FF preferred stock are generally issued to the founders upon incorporation or immediately prior to the Series A round.

2)      The shares are generally identical to shares of common stock, except they are  convertible at the shareholder’s option into shares of the same series of preferred stock issued in a later round (provided that the buyer of the Series FF shares purchases them as part of that round and pays the same price as the preferred stock being issued).

3)      The conversion of the shares of Series FF must be approved by the issuer’s Board of Directors.

As noted above, the significant advantage of issuing Series FF preferred stock is that it allows the founder(s) to take a few chips off the table.  Indeed, for many founders, the opportunity to cash-out is quite appealing, particularly where they have run-up significant credit card debt and/or are interesting in buying a home for their family.  The amount of the cash-out, however, is generally capped to between 10 and 15 percent (depending upon the round of financing).

The other advantage is that it is a clever way of avoiding issues relating to the increased pricing of options if investors were to buy founders’ common stock, as opposed to preferred stock (converted from the Series FF).

Obviously, the significant disadvantage of issuing Series FF stock is that it may deter investors from investing because investors generally want founders to be “all in” and not pull any money out of the venture.  That being said, there are circumstances where investors permit founders to take some money out, but usually it’s done through a mechanism other than Series FF stock.

Other disadvantages include an added layer of complexity (thus increased legal fees, among other things) and potential litigation from other stockholders (including employees of the company) if the company doesn’t have a successful exit.  Indeed, in the event of litigation, it may be difficult for the founders and/or the Board of Directors to justify having investment funds arguably diverted from the company.

Conclusion

The bottom line is that Series FF stock (like Class F stock) is relatively new and its issuance is not widespread.  Accordingly, for first-time entrepreneurs, it probably makes sense to keep it simple and just issue ordinary shares of common stock.  Nevertheless, I wholeheartedly support any effort to help founders better align their interests with their investors.

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