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Should I Implement Dual Class Stock for My Startup?

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A typical startup company authorizes one class of Common Stock with simple rights.  An example of such rights is that each share of Common Stock is entitled to one vote on all matters subject to stockholder approval.

However, as valuations have grown and venture capitalists compete for deals, founders of certain startup companies have gained negotiating leverage to implement a dual-class Common Stock structure that provides additional rights to the founders. You may have heard this referred to as “Class A” and “Class B” Common Stock.

We get lots of questions about this dual-class structure here at Atrium, leading us to compile this document of common questions and our answers.

What is dual-class stock?

Dual-class stock is a capital structure where founders hold shares of common stock with greater than 1x voting rights, while other common stockholders have shares with standard 1x voting rights. Dual class common stock enables founders to maintain control through “super” voting powers when they raise money through future equity financings.

Over the years, a number of companies have implemented dual-class stock. Such a structure became popular among certain family controlled media businesses and more recently among high growth technology companies, including Google, Facebook and Zynga (to name a few).

Essentially, the idea is that:

  • Class A shares mirror the typical Common Stock described above, with 1x voting rights.
  • Class B shares have greater than 1x voting rights, e.g., 5x or 10x, and, in some cases, other rights preferences and privileges not held by the Class A shares. These may include:
    • Automatic conversion into Class A stock upon a sale or transfer; and
    • Protective provisions requiring Class B stockholder approval for certain material events, such as charter amendments, liquidity events, and payment of dividends.

Why use dual-class stock?

Holding high vote shares allows founders to maintain voting control of their companies, even in cases where several rounds of venture financing have caused significant dilution resulting in founders owning a relatively small piece of their company, and even following an IPO.

We have seen some recent early-stage financings where founders of hot startups were able to maintain high vote shares while investors purchased preferred stock convertible into the low vote shares. This demonstrates that in the current competitive marketplace more startup founders have the leverage to implement this founder friendly structure, and keep it when raising their Series A and beyond.

Why bother with high vote shares?

Generally, Preferred Stock will convert to Common Stock upon an IPO. At this time, investors lose the benefit of the protective provisions, liquidation preference, and other rights specific to the outstanding preferred stock. As discussed, this can give investors the ability to block significant corporate actions.

After the Preferred Stock has converted to low vote Common Stock, the high vote shares could easily outvote the low vote shares (depending on the high vote multiplier you use and number of shares outstanding), 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 at the time of a financing if you have low leverage and need to get a deal done.  But the upside of having long term control is high.  We see real life examples each day in the case of companies like Google and Facebook where executives can focus on long-term growth due to founders retaining high vote shares.

Why founders are often hesitant to use dual-class stock structure

Many founders make the following (false) assumption about dual-class common stock:

“High vote shares are fine in the case of hot companies like Facebook, but a high vote/low vote structure isn’t appropriate for most startup companies like mine. Especially since VCs won’t find it acceptable. Therefore, I shouldn’t bother implementing this structure in the first place as I’ll ultimately need to unwind it.”  

I have found this to be untrue on several occasions. Market conditions are making investors more and more amenable to this option, as I discuss in the next section.  Unfortunately advisors, including company counsel, often perpetuates this false assumption in order to avoid complexity in the present or future.

How to convince your investors

Many VCs want to be perceived as “founder friendly,” so they generally will not take the position that the founders’ long-term control over the company is a bad thing.

If anything, they may 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, because VCs will require that a startup company agree to certain “protective provisions” in a term sheet as a condition to the investment.

Namely, VCs are going to require investor approval before you can take certain actions, such as:

  1. Amending your certificate of incorporation, which is going to be needed in order to raise the next financing round.
  2. A liquidation event, so no exit without VC approval either.

Both amending a certificate of incorporation and selling your 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 1,000x voting rights, since the negotiated protective provisions generally will give investors the right to vote as a separate class and/or series vote on these key decisions.

How dual-stock structure can work for your company

Startup founders should at least consider the most basic dual-class Common Stock structure, where the one class has 10x voting and the other class has 1x voting, but otherwise the classes are identical.

The high vote shares could have other features, such as:

  • Automatic conversion to low vote upon a transfer or sale to a third party
  • Optional conversion to low vote shares at the election of the holder
  • Protective provisions requiring approval of the holders of high vote shares for certain actions, like M&A.

To learn more about how your startup can implement a dual-stock structure, feel free to reach out.

This post is for informational purposes only and not legal advice. You should contact your attorney for advice regarding dual-class Common Stock structures.  

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Jon O’Connell is a Partner and founding member of Atrium’s legal team. He advises startup clients on matters ranging from corporate governance, capital raising, commercial transactions, and mergers and acquisitions. He also represents venture capital funds in equity financings. From 2017-2019, he managed Atrium’s venture capital financing team which was one of the most active venture capital financing teams in the industry having completed over 100 preferred stock equity financings in that time period. Prior to joining Atrium, he practiced at Morrison & Foerster in San Francisco and Wilmer Cutler Pickering Hale and Dorr in Palo Alto. At these firms, he often acted as outside general counsel for hundreds of startups in industries ranging from foodtech to fintech. He joined Atrium in order to enhance the client experience through the application of technology and operational improvements. As one of the first attorneys to join Atrium, he helped pioneer the development of Atrium’s industry-leading legal technology tools that automate workflows like complex pro forma cap table generation. When he’s not working, you can find him caring for his newborn daughter, golfing, watching sports, or gardening his backyard where he grows vegetables and raises chickens. He’s also active in his professional networks often speaking at industry events like Tech GC’s Fullstack Conference. Jon received his J.D. from Santa Clara University School of Law and Bachelor’s Degree from the University of California, Santa Barbara.

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