Preferred stock is a class of capital stock created under a company's certificate of incorporation that gives its holders certain relative preferences and other special rights over the holders of common stock. The rights and preferences of preferred stock are traditionally designed to meet two primary objectives:

Preferred stock offers a company and its stockholders the contractual flexibility to structure equity investments to meet these objectives and the other rights and preferences desired by the parties. Because the terms for preferred stock are so malleable, companies issue preferred stock in a variety of contexts. Even within the realm of private equity, capital-raising transactions, the terms can vary widely depending on the particular circumstances. However, certain forms of preferred stock and the related CODs are commonly associated with particular capital-raising transactions.

The following discussion of different forms of preferred stock common to several different transaction types is taken from the opening drafting note in PLC Corporate & Securities' newest resource, Standard Document, Certificate of Designation of Preferred Stock (Convertible, Double-dip Participating).

The most basic form of preferred stock used in a private equity capital-raising transaction typically has:

However, after the payment of the liquidation preference, the preferred stock does not participate with the common stock in the payment of liquidation proceeds and is not otherwise convertible to common stock. As a result, it does not share in the capital appreciation of the common stock, either by the right to convert to common stock or otherwise by the terms of the liquidation preference. This sets up a two-class structure in which the preferred stock receives liquidation proceeds before the common stock, but the common stock receives the entire residual value of the company that remains after the liquidation preference has been paid (whether on an actual liquidation or a deemed liquidation following a sale of the company) (see Drafting Note, Deemed Liquidation).

This type of preferred stock is commonly seen in buyout deals, where the sponsor purchases a combination of preferred stock and common stock (or warrants) when financing the buyout.

This class of preferred stock has characteristics of both preferred stock and common stock. As in the form above, the preferred stock has a fixed, accruing dividend and a senior liquidation preference to return the capital invested and accumulated, unpaid dividends ahead of the common stock. However, the stock is also structured so that, in addition to these payments, it shares in any capital appreciation of the common stock by participating with the common stock up to a stated fixed percentage of:

This participation feature is known as a double-dip participation because the liquidation preference is structured to provide the holder with both its basic liquidation preference as well as its share of the common ownership residual value, thereby double dipping in the company's equity value. This form, as opposed to convertible, double-dip participating preferred described below, is non-convertible, with the residual participation built into the liquidation preference itself. The COD for this form does not include conversion or anti-dilution provisions.

This form of preferred stock is often used in a buyout or other acquisition involving a rollover of common equity by target management or other target stockholders. The participation features of the preferred stock help facilitate a tax-free rollover for the existing target stockholders, deferring tax on any gain on the stock rolled over in the acquisition. This type of preferred stock is either the only class of stock issued in the buyout or, more typically, issued as part of a two-class structure with a class of common stock (used for non-rollover equity issuances and management equity incentives in the buyout).

This form of preferred stock has a fixed dividend, but it may or may not accrue or accumulate. It also has a senior liquidation preference entitling the holder to its capital invested plus any declared (or accumulated, if applicable), but unpaid dividends ahead of the common stock. Unlike straight preferred stock, this preferred stock can share in the capital appreciation of the common stock because it is convertible into common stock. The effect is that the holder is entitled to either the:

A holder typically chooses whichever option is greater from an economic standpoint, but cannot have both.

The preferred stock is non-participating even though the holder can choose to share in the upside of the company because the liquidation preference itself does not contain the upside participation. Rather, the holder must affirmatively convert the preferred stock to receive the participation. For more on this distinction and participation features, see Drafting Note, Participation.

This form is commonly found in early-stage venture capital investments. Due to the speculative nature of these companies, a venture capital investor typically is not relying on the stable, fixed-income aspects of a preferred stock investment, but is counting on the upside of the common stock capital appreciation. In many cases, this form of preferred stock may not accrue a fixed dividend (many early-stage companies cannot pay them) or, if it does, the dividend does not accumulate and is only paid if declared by the board. This form of preferred stock can also be used in buyouts with a management rollover as an alternative to the non-convertible, double-dip participating preferred stock.

This form of preferred stock has the same economics as the convertible, non-participating preferred stock, but the liquidation preference itself is participating. This means the holder can receive the greater of:

The preferred stock does not need to be affirmatively converted to get the benefit of its ownership share of the residual value of the common stock (and typically is not converted). In addition, as with the convertible, non-participating preferred stock, the holder does not receive both the basic liquidation amount and the common ownership participation (it is not a double-dip participation). The preferred stock retains its conversion features so that the holder still benefits from the anti-dilution protections of the conversion provisions (with the as-converted amount of the liquidation preference measured as of the date of liquidation). For a discussion of these provisions, see Drafting Note, Adjustment to Conversion Price and Number of Conversion Shares.

This form of preferred stock is often seen in both venture capital transactions and in later-stage growth equity investments. It can also be used in buyouts to help achieve a tax-free rollover.

This form of preferred stock has the same economics as the non-convertible, double-dip participating preferred stock used for some buyouts (with the double-dip participation built into the liquidation preference). However, the participation in the residual value of the common stock is not stated as a fixed percentage in the liquidation preference (as it is with the non-convertible, double-dip participating preferred stock), but as an amount the holder would receive on an as-converted basis as if the preferred stock is converted on liquidation. Therefore, the preferred stock does not need to be affirmatively converted to get the benefit of the double dip. In addition, with this form, the preferred stock retains its conversion features so that the holder still benefits from the anti-dilution protections of the conversion provisions (with the as-converted amount of the liquidation preference measured as of the date of liquidation). For a discussion of these provisions, see Drafting Note, Adjustment to Conversion Price and Number of Conversion Shares.

This form of preferred stock is very favorable to the holder from an economic standpoint because the holder can receive in an upside exit scenario both the basic liquidation preference as well as its pro rata share of any residual value in the common stock, thereby double dipping in the company's equity value. Sometimes this preferred stock contains a cap on the double-dip participation in the liquidation preference (after which the holder receives no further liquidation proceeds), usually a multiple of return on the original liquidation value of the preferred stock (such as a two-times (2x) multiplier). In these cases, retaining the conversion feature has the additional benefit to the holder of preserving the ability to convert to common stock in the event the exit return on the common residual value is greater than the 2x return and the holder would be better off converting compared to receiving the double-dip participation. If there is no cap on the double-dip participation, however, this additional benefit of the conversion feature is unnecessary as the holder always receives its full double-dip participation.

This form of preferred stock is most often used in a late stage, growth equity investment. It can also be used in buyouts to help achieve a tax-free rollover due to the participation features of the stock.

Practical Law Company's Standard Document COD assumes a series of convertible, double-dip participating preferred stock (without a cap) for use in a late-stage, growth equity investment. As is common with many target companies for growth equity investors, this Standard Document also assumes that the company has received multiple rounds of prior financing before the growth equity investment, including prior preferred stock investments from sophisticated venture capital investors.

The features of this COD, which are common for this type of preferred stock, include: