When deciding how to capitalize the company and issue stock to founders, most companies’ capital structure is such that the owners receive common stock while a reserve option pool of common stock is left for employees, consultants and service providers. There is also a pool of preferred shares that is reserved for different financing rounds. However, increasingly companies are beginning to include another class of stock aimed at granting company founders rights normally associated with preferred shares. These shares are referred to in company documents using many different names; sometimes we see them referred to as FF Shares, X shares, or Class F Stock. For ease of reference, we will refer to them as X Shares in this article.
Common attributes of X Shares
X Shares tend to have one or two common features and are normally authorized in the company’s articles of incorporation or other charter documents. The first feather is a right of conversion, something that is more often associated with preferred shares. X Shares that have conversion rights grant the holders the right to convert their X Shares into any future round of preferred stock and to be sold by the founders at the same price and on the same conditions as the company’s direct sale to its investors. More often than not the X Shares are convertible only in connection with a financing initiated by the company where the investors are agreeing to purchase some shares directly from the company (referred to as the “primary” offering) and other shares from the founders (the “secondary” offering). The conversion and sale of X Shares by the founders will often require additional board approval at the time of financing. The second right associated with X Shares is superior voting rights to other forms of common stock. For example, X Shares will typically grant the holders more than one vote per share and may also include board appointment rights or grant a board seat to holders of X Shares.
Advantages of issuing X Shares
The motivation for X Shares is easy to see. It has the twin benefits of granting founders greater control over common stock holders and provides holders with the potential for an early liquidity event or an early exit. These features allow owners greater control and say in the company’s direction than those who have common stock and provides the X Share holders, normally the company founders, with the possibility for an early liquidity event and could potentially offer them an earlier exit than other holders of common stock.
Potential drawbacks to issuing X Shares
While these benefits may appear attractive on the surface, issuing X Shares is not without its drawbacks and potential pitfalls. Investors are leery of any arrangement that allows founders to get liquidity before they do and investors will be concerned with the idea of founders diverting funds from the company and into their pockets. The issue of voting rights attached to the X Shares will also put investors on alert as control will be one of the key issues for any investor. It is a tacit, if not explicit, agreement with any large investor that in return for my cash I will have a significant say in the direction of the company. The increased voting and board appointment rights associated with X Share ownership will no doubt scare away investors who are looking for maximum return on their investments.
When considering whether to issue X shares, founders should sit down with their legal advisors understand all the tax and other issues associated with issuing this class of stock; any issuance of unregistered securities must comply with the Securities Act of 1933 and any resale of those shares may trigger Rule 144 of the Securities Act, which governs the resale of restricted securities. Equally important will be a discussion with advisory board members on how the issuance of X Shares may impact the company’s ability to attract future investors. Compensating founders fairly while still leaving the business attractive for potential investors is a high wire act that all startups and emerging growth companies face. The key is to balance the immediate desire for control and an early liquidity event with the concerns that such an arrangement will raise with future investors.
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