Preferred Stock

What is preferred stock?

Preferred stock (German: Vorzugsanteile nach US-Recht) describes, in US corporations, a class of shares with privileges over ordinary shares (Common Stock). The most important privilege is priority in the distribution of proceeds when the company is sold or wound up (exit). The term preferred shares is equivalent; the German rendering "Vorzugsaktien" is imprecise, as explained below. In venture capital financings there, the investors receive preferred stock, while founders and employees hold common stock.

German companies encounter the term in the term sheet of international investors, in due diligence questionnaires and in comparisons with US funding rounds. A GmbH (German limited liability company) does not issue preferred stock. The economically corresponding rights are reproduced through preferred GmbH shares (Vorzugsgeschäftsanteile), that is, shares to which the articles of association assign special rights (Sonderrechte), and through the shareholders' agreement. Despite the similar name, preferred stock has little in common with the German preference share under the German Stock Corporation Act (Aktiengesetz, AktG): the latter generally carries no voting rights.

Rights of preferred stock in the US market

In the US market, each funding round is usually issued as its own series. The first larger round with venture capital investors is called Series A Preferred, for instance, and the next Series B Preferred. The rights of each series are set out in the company's founding document (certificate of incorporation) and in accompanying investor agreements. A bundle of six rights is typical:

• Liquidation priority: priority on a sale or winding up, usually in the amount of the investment, structured as a liquidation preference.
• Conversion right: the right to convert into common stock at any time, combined with automatic conversion on a qualified IPO.
• Anti-dilution protection: an adjustment of the conversion ratio if shares are later issued at a lower price (Anti-Dilution Protection).
• Consent rights: vetoes of the series over fundamental measures such as capital measures, a sale or amendments to the articles (Protective Provisions).
• Voting and board rights: a vote as if already converted into common stock (as converted), and often the right to elect members to the governing body of the US company.
• Dividend preference: in venture financings usually non-cumulative, so preferences that were not paid are not made up later; it matters only if distributions are actually made.

The German preference share under the Stock Corporation Act

The Stock Corporation Act permits shares with different rights; shares with equal rights form a class (Gattung) (Section 11 AktG). The statutory type of preference share, however, pursues a different purpose from preferred stock. Under Sections 139 et seq. AktG, the shareholder receives a preference in the distribution of profit, such as a priority dividend, and in return the voting right can be excluded. In practice, the preference share is therefore generally a non-voting share. Non-voting preference shares may be issued only up to half of the share capital (Grundkapital) (Section 139(2) AktG). If the preference is not paid, the voting right revives under the statutory rules.

The non-voting preference share serves to raise equity without changing the voting ratios. It is found mainly in listed companies with a dominant majority shareholder. Preferred stock pursues the opposite aim: besides priority in proceeds, the investor receives additional influence through voting rights, consent rights and seats on supervisory bodies. A German AG can nevertheless structure an investor class in the venture capital sense as its own class, for example with liquidation priority and full voting rights.

Implementation in a GmbH: preferred GmbH shares

The German Limited Liability Companies Act (GmbH-Gesetz, GmbHG) does not expressly regulate classes of shares but allows wide freedom of design. The articles of association can assign special rights to individual shares. This includes in particular a different standard for the distribution of profit (Section 29(3) sentence 2 GmbHG) and of liquidation proceeds (Section 72 sentence 2 GmbHG). The shares issued in a funding round are then designated as preferred GmbH shares or by the round, for example as Series A shares. A conversion of votes as in the US market does not apply: each euro of a share carries one vote (Section 47(2) GmbHG). The premium, that is, the amount the investor pays above the nominal amount, does not count for this. The articles of association can deviate from this.

Allocation between articles of association and shareholders' agreement

• Articles of association: priority in profit distribution and liquidation, consent requirements of the shareholders' meeting, transfer restrictions (Vinkulierung, transfer of shares only with consent), redemption rules and, where applicable, an advisory board with appointment rights.
• Shareholders' agreement: distribution of proceeds on a sale of shares, anti-dilution protection, tag-along rights and drag-along obligations, rights of first refusal, information rights and the catalogue of management transactions requiring consent.

Rights in the articles of association take effect against every shareholder and, as a special right, cannot in principle be withdrawn from the holder without its consent. The articles of association can, however, be inspected by anyone through the commercial register. The shareholders' agreement remains confidential but binds only its parties. Both documents are generally notarially recorded; the capital increase through which the investors receive their shares becomes effective only on entry in the commercial register.

Preferred stock in valuation and due diligence

Because preferred shares carry more rights than ordinary shares, the price an investor pays per share is not the value of an ordinary share. The post-money valuation of a round results from this price. It therefore overstates the value of the founders' shares as long as realistic exit proceeds are in the range of the preferences. This distinction must be borne in mind in purchase negotiations and valuation reports.

In due diligence, the review of the company before the investment, new investors and acquirers clarify whether the rights of each series are documented consistently. They also check whether later rounds have adjusted the rules of earlier series and whether all shareholders have acceded to the agreement. If one of these conditions is missing, the distribution of proceeds on an exit cannot be calculated reliably.

Practical example: US term sheet with preferred stock for a GmbH

A software company in the legal form of a GmbH with annual recurring revenue of EUR 6 million receives the term sheet of a US investor for a Series A. It provides for Series A preferred stock with a simple non-participating preference, weighted average anti-dilution protection, protective provisions, a seat on the board and pre-emptive rights for future rounds. The law firms translate the terms as follows:

• Series A preferred stock: new shares from a capital increase, designated in the articles of association as Series A shares. The investor pays the nominal amount and the premium, where applicable plus an additional payment into the capital reserves.
• Non-participating preference: a proceeds distribution rule with credit, in the shareholders' agreement and the articles of association.
• Weighted average anti-dilution protection: the obligation of the existing shareholders to enable the investor, in a round at a lower price, to receive compensating shares at the nominal amount (Weighted Average).
• Protective provisions: consent requirements in the articles of association and the shareholders' agreement, tied to a majority of the Series A shareholders.
• Board seat: a seat on an optional advisory board or an observer right; the managing directors remain the management body of the GmbH.
• Pre-emptive rights: the right to participate proportionately in future capital increases (Pre-emptive Rights).

Economically, the result largely corresponds to the US model. The difference lies in the form: the rights are not attached to a share class but are spread across several documents that must be coordinated with one another.

Distinctions: preferred stock, common stock and preference share

• Common stock: the subordinated ordinary shares without preferential rights; their equivalent in a GmbH are the ordinary shares.
• Preference share under the AktG: a profit preference, mostly in exchange for the voting right. Preferred stock, by contrast, combines priority in proceeds with additional control rights.
• Liquidation preference: the economically most important single right of preferred stock, which in a GmbH can also be agreed without any special designation of the shares.
• Convertible loan: a loan that is converted into shares in the next round, usually into shares with the rights of that round.

Common mistakes

• Literal translation as preference share. Anyone who equates preferred stock with the German "Vorzugsaktie" expects non-voting shares and underestimates the influence that investors actually receive.
• US clauses adopted unchanged. References to bodies of a US company, to US company law or to a conversion of shares have no point of connection in a GmbH and must be translated into German mechanisms.
• Rights only in the shareholders' agreement. Without a provision in the articles of association, profit distributions and the distribution of liquidation proceeds may not be covered by the priority.
• Series not coordinated. If a new round introduces its own rights without adjusting the rules of earlier series, contradictions arise regarding ranking, consents and anti-dilution protection.
• Round price taken as the value of ordinary shares. The price per preferred share contains the value of the preferential rights and is no yardstick for the value of the founders' shares.

Frequently asked questions

Is there preferred stock in a German GmbH?

No, not as a statutorily structured class of shares. A GmbH achieves the same effect by assigning special rights to individual shares in the articles of association and regulating the remaining investor rights in the shareholders' agreement.

What is the difference between preferred stock and common stock?

Preferred stock is served first on an exit and carries additional protective rights; common stock receives only the remaining proceeds. Investors therefore generally hold preferred stock, founders and employees common stock. A common stock share in a growth company is regularly worth less than the price investors pay per preferred share.

Do holders of preferred stock receive a fixed dividend?

In venture capital, mostly not. The dividend preference there is generally non-cumulative and applies only if the company actually makes distributions, which growth companies rarely do. It is different for exchange-traded preferred stock of established US companies, for example banks. This form of investment usually pays a fixed dividend ahead of the ordinary shares and generally has no voting right.

Is preferred stock the same as a preference share?

No. The German preference share under Sections 139 et seq. AktG typically grants a profit preference without voting rights. Preferred stock in venture capital combines priority in proceeds with voting rights and consent rights.

Do investors with preferred GmbH shares have a voting right?

Yes. In a GmbH they vote like all shareholders according to the nominal amount of their shares. In addition there are consent rights with which they can block certain resolutions regardless of their stake.

Do German companies need a US company for US investors?

Not necessarily. US investors also take stakes directly in German GmbHs; the familiar rights are then reproduced in the articles of association and the shareholders' agreement. Moving the company under a US holding company (a so-called flip) is a project in its own right, whose tax consequences for the German shareholders must be clarified in advance.

The Roemer Capital view

Term sheets of international investors are often drafted in the terminology of preferred stock. Roemer Capital goes through such drafts with the company point by point. Together with the company's law firm, it clarifies what the German equivalent of each clause is and whether it has the same economic effect in a GmbH.

For founders and management, Roemer Capital additionally translates the preferential rights into figures: what proceeds fall to the ordinary shares at different sale prices and which consent requirements affect the future steering of the company. In this way a catalogue of foreign-language rights becomes a basis for decision.