A startup founder’s desire to hold equity better than plain-vanilla common stock isn’t new. Several years ago, Series FF stock for founders was all the rage when it came to founder liquidity at subsequent financing rounds. We implemented Series FF for a handful of clients back then but we haven’t done so recently. In the past couple years, we’ve been receiving frequent requests for, or at least questions regarding, setting up a dual class common stock structure in order to create super voting rights for one or more of the founders. (And we suspect, of course, this is because large technology companies like Google and Facebook have implemented this type of structure.) The founder(s) is usually worried about losing control down the line and wants to obtain super-voting rights with their shares via this dual class common stock system.
The Dual Class Common Stock Setup
The usual method to create super-voting rights for a founder is to implement a dual class common stock structure, generally the “Class A” and the “Class B”. The Class A and Class B will be identical (economically at least) except for one thing: voting power. Usually it is the Class A that will have a multiple of votes per share; and most typically we see a 10-to-1 multiple. For example, the Class A Common Stock will have 10 votes per share and the Class B Common will have 1 vote per share. Then at the outset of the startup, one or more of the founders would be issued Class A Common Stock, and everyone else such as employees, advisors, consultants would receive the Class B Common Stock.
Benefits of the Dual Class Structure
As with everything else, there are positives and negatives to a dual class structure.
The positives are for the founders (and any other stockholder that trusts the decision-making ability founders) in that as the company takes on additional stockholders and the founders get diluted, they are able to maintain control of the startup. If a founder has a 10-to-1 multiple then he or she only needs a smaller percentage to maintain control, much smaller than 50% anyways.
This is why the structure is so appealing. Generally, founders put their blood, sweat and tears into their startup and the thought of losing control is extremely frightening and this structure gives them comfort. They may reason that the other smaller stockholders should not be able to collectively overrule the founder on company decisions. This seems to make sense, but why isn’t this a good idea to always be implemented?
Potential Red Flag?
A dual class structure might scare off potential investors or even future hires. Leaving aside potential ways for investors to use other voting mechanisms of control (such as protective provisions), sometimes the dual class structure can set off a red flag to a potential investor or hire that the founder already thinks he or she is Mark Zuckerberg even though the company may not have even closed a customer or obtained a user. Yes, Facebook got significant investment, as have many other companies with a dual class structure, but Facebook was extremely successful and had their choice of prominent investors. (It is also worth mentioning here that Mark Zuckerberg has also maintained control through proxy. In other words, not only does he have the dual class structure, but he also has voting control over a substantial amount of shares that are not owned by him.)
The take home here is that it’s helpful, if not almost required, to have leverage or some compelling reason to warrant the dual class structure. So, unless you are a very “hot” startup and/or investors have extreme faith in you and your vision, it is somewhat rare that an investor will approve of the dual class structure.
Preemptive Strikes Don’t Work by Themselves — You Need Leverage
Some people believe that installing the dual class common stock structure ahead of ever seeking investment gives them leverage to keep it. I’m not confident about that. Sure, a dual class structure could be built into your certificate of incorporation, but in the startup world, certificate of incorporations are made to be amended and restated. In other words, it’s not a huge legal exercise to get rid of the dual class structure as it only requires the filing of an amended/restated Certificate of Incorporation. And this is likely already going to happen as part of that financing.
Again, it just goes back to your leverage. Note that we frequently hear from founders who want to ‘game’ their vesting schedule with the same false belief that if they install a founder-favorable vesting schedule, it is somehow difficult for a future investor to change it. When in reality, it’s just a quick amendment to one or two subsections of a founder’s restricted stock purchase agreement. If it’s not a rationale position, just because you have written it down doesn’t mean it’s point where the negotiation should commence.
Tips on Implementing a Dual Class Structure
If you are set on having a dual class common stock structure, you should make sure that it actually is set forth in your Certificate of Incorporation. We have seen a few companies discussing their dual class structure, when they do not have a dual class structure. In order to properly implement the dual class structure, it needs to be in your Certificate of Incorporation. And when your startup issues common stock, it needs to be very clear which class is being issued.
Additionally, you should also seriously consider installing various mechanisms that convert the super-voting shares (the Class A) to normal voting shares (both optionally and automatically). Some examples of this are: (i) optional conversion at the option of the holder, (ii) automatic conversion upon the majority vote of the super-voting shares and (iii) automatic conversion upon any transfer of the shares.
In general, I wouldn’t recommend as a default that startups implement the dual class common stock structure. If you have leverage, you’ll be able to install it at a later date. That being said, we have been installing these dual class structures more frequently, but I doubt this will become the norm.