Preferred Stock: What Is It?

When starting a new business venture or trying to expand your existing business, the key is the level of capital (cash) that will be required to accomplish the new start-up or expansion. Typically a business owner will inject its own internal capital partnered with a certain level of bank financing to facilitate the project. Unfortunately, many times the small business owner isn't able to come up with the required cash to qualify for the financing options, nor does he/she have the means; the owner may not have readily available cash, existing equity in business assets, nor personal assets to use as collateral or liquidate to provide the needed cash. This is where many great ideas are left, just as dreams, with no opportunity to see the plan through.

If all efforts to create capital to inject have been exhausted, there are creative capital alternatives that rarely get utilized. The alternatives are bringing in a partner (which usually is a long-term, permanent disposition of a percentage of business ownership) or sell part of the business to a local or regional venture capital investor to raise the required capital. These alternatives are not easy for a small business owner to understand or to accept, however, it will allow the owner to accomplish the ultimate goal and dream for their business in the long term. Additionally, if structured correctly, this can also allow the re-purchase of the ownership back when the company has the financial capability. This second alternative is the subject of this discussion.

The most typical process for this type of transaction is to sell Preferred Stock in the business to an investor. Preferred Stock is quasi-ownership of a company with specified limitations. The preferred stockholder injects a certain amount of dollars in capital for an agreed upon percentage ownership and in return will receive a negotiated return on this investment until the stock is retired. The preferred stockholder does not typically have voting rights in the company but can require certain conditions to be met. However, if the business is sold for profit or closed due to financial difficulty, the preferred holder is paid its original investment plus the required return first from the proceeds of the sale, or liquidation of the company, before the business owner receives any proceeds.

The keys to a successful preferred stock arrangement are as follows:

1) Find the right investor. This investor needs to understand your business and be flexible in their requirements of the company. You can consult with your banker, lawyer, accountant or others you know that are interested in this type of investment.

2) Negotiate a reasonable return and ownership percentage with the investor. Also, you should understand all of the conditions and/or requirements that the investor will require and how they might impact your business.

3) Ask your lawyer to draw a Preferred Stock agreement that outlines and insures your understanding of the transaction.

The benefit of a Preferred Stock transaction is that you get to immediately proceed with the start-up or expansion of the business. Additionally, you can retire (payoff) the preferred holder at any time (assuming there is no time limitations on retirement) and regain total ownership when the company has better financial footing.

A Preferred Stock transaction is definitely not what is normally considered when starting up or expanding your business. However, instead of just "giving up" on your dreams, this is a very successful, tested and proven means of "Making Your Dreams a Reality."