[Note: this post will likely get updated in the near future.]
I’ve been asked by a few people about the Series FF stock that has been advocated by the Founders Fund. Matt Marshall of Venture Beat reported on this invention in December 2006. See here for an Inc.com report in March 2007. Michael Martin blogs about economic incentives associated with the Series FF and founders receiving some liquidity in connection with a venture financing. Series FF stock has also recently received some attention due to the announcement of the Founders Fund raising a $220 million fund in December 2007. See additional coverage from Venture Beat, TechCrunch and the Mercury News.
I’ve reviewed the Certificate of Incorporation of a couple of WSGR clients that have implemented Series FF stock. (Please note that anyone can obtain the Certificate of Incorporation of a Delaware company from the Secretary of State of Delaware.)
The Series FF is an interesting mechanism for founders to obtain liquidity in connection with a venture financing. Below are the main features of the Series FF stock:
- The Series FF is basically identical to common stock except that it is convertible at the option of the holder into the same series of preferred stock issued in a subsequent round of equity financing if the buyer of the Series FF purchases it in connection with the equity financing.
- The conversion into preferred stock can only occur if the buyer of the Series FF pays the same price per share as the shares of preferred stock sold in the equity financing.
- The conversion into preferred stock can only occur if the board approves the conversion.
- The Series FF is convertible into common stock at any time at the option of the holder.
- The Series FF automatically converts into common stock upon a qualified IPO or upon the consent of holders of a majority of Series FF.
By the way, the Series FF preferred stock doesn’t need to be called Series FF. It can be called Series A, Series Q, Series Z, Series X, etc. The Founders Fund has managed to do some branding by referring to it as Series FF.
Below are some things to keep in mind about Series FF stock:
- Pricing of the stock is complicated. Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). If the Series FF is not issued at initial incorporation, then issuing the Series FF stock at a later point in time will require the founders to pay more than a nominal amount to purchase the shares. As I will describe in a later post, founders stock is typically issued at a very nominal price per share, such as $0.001, so that the company may initially issue 10,000,000 shares for $1000.
- If the Series FF is issued immediately prior to the Series A financing, then the price per share of the Series FF probably should be at least the same as the Series A. In some respects, the Series FF may be more valuable than the Series A in the future if it can convert into a later round of preferred stock with a liquidation preference greater than the Series A. On the other hand, there is significant risk that the holder never receives liquidity because the board might not allow a conversion to occur (or investors may not be willing to purchase).
- Legal fees incurred in issuing Series FF may be higher. This is because the Series FF receives some amount of custom drafting and tweaking compared to a typical incorporation. In addition, many attorneys are not familiar with the concept and there are costs incurred in “reinventing the wheel” and getting everyone comfortable. The additional costs involved in setting up the Series FF may be wasted if the future board does not allow the founders to obtain liquidity.
- It is unclear whether venture funds are willing to allow founders to sell a portion of their stock in connection with a venture financing. Implementing the Series FF before an equity financing sends a message to potential investors that the founders want liquidity in connection with an equity financing. This may not be a good thing to mention when looking for early rounds of financing. However, venture funds may be willing to allow founders to sell in the following situations:
- The venture fund has to agree to it because there are multiple terms sheets in a competitive deal.
- The company is doing well (i.e. valuations above $100M and nearing an IPO) and the founders would rather sell the company that wait longer for liquidity.
- Investors prefer to purchase newly issued shares supported by a legal opinion, representations and warranties and various contractual rights. I’m not sure what benefit the company receives by facilitating the sale by the founders as the company does not receive the funds from the investors.
- Other mechanisms exist to allow founders to receive liquidity in connection with a venture financing. Companies can repurchase founders common stock for cash, subject to various limitations. The main issue that the Series FF solves is the price difference between preferred stock and common stock. If common stock is repurchased by the company at the same price as preferred stock is being sold to investors, then the fair market value of the common stock for option pricing purposes probably should be the preferred stock price. However, in a company nearing an IPO, the common stock FMV will likely be very close to the preferred stock price anyway. Therefore the Series FF stock probably only incrementally solves for a situation where founders want liquidity and want to preserve a significant price difference between the common stock and preferred stock in an early stage venture financing. (I’ll write a future post about option pricing and 409A in the near future.)
- Because the Series FF will likely only be issued to founders due to timing and pricing issues associated with issuing the Series FF, other employees may be upset that founders are receiving some liquidity.
- There is some risk of claims against the founders that sell (and the board) if the company never reaches a liquidity event. The other stockholders (including disgruntled employees) might argue that the company should have issued new shares to the investors and received the funds that the founder received from selling the stock.
- Despite carefully drafted releases, venture funds may reluctant to purchase the shares due to potential claims by disgruntled founders that they were forced to sell their stake at a low price compared to the price in an eventual liquidity event.
I am curious to see whether the Founders Fund has managed to invent something that will be broadly accepted or just a novel feature that is occasionally used by companies that have a connection to the Founders Fund.
I will likely update this post (without warning) with more thoughts as I hear feedback from various people.