Why I'm Skeptical of "Class F" Common Stock

Five weeks ago, I wrote about the efforts of TheFunded.com to promote a standard term sheet for first round financings. In a subsequent post, I suggested that a standardized, simplified first round stock purchase agreement would do more to control legal fees than a streamlined term sheet. I've been making progress since on a model stock purchase agreement.

Well, last week, TheFunded.com published founder friendly legal documents for use in organizing startups. I had to assess how those documents might impact the stock purchase agreement project.

One of TheFunded.com documents is a template charter for a Delaware corporation. It's well-drafted (it may have been authored by Yokum Taku). Unfortunately, I have to report that TheFunded.com's recommended charter is at odds with its cause of simplifying first round financings. If used, this charter can only increase legal fees for a first round financing.

Some background on basics: a company's charter establishes its capital structure. For a tech startup, a charter will typically authorize two kinds of stock, common and blank check preferred. Alternatively, the initial charter may authorize only common stock, since the charter will be amended later anyway to specify the rights and preferences of the preferred sold in the first round (typically designated "Series A").

But TheFunded.com's charter is not typical. Instead, it establishes two classes of common stock, a super "Class F," and a subordinate "Class A."

The features of the Class F common stock include:

• super-voting privileges; 
• protective provisions analogous to those of simple preferred stock; and 
• the right to elect a director who has two votes on the company's board. 

A thorough summary of the features of Class F common can be found on Yokum Taku's blog, here.

When it comes time to raise an outside round, a capital structure with a class of super common is going to have to be explained. If the founders are serious about it, it is going to have to be defended. If it is successfully defended, the process will yield a third class of stock, one featuring terms designed to mitigate or match the powers of the Class F stock. And even assuming that the dual-class-of-common structure is surrendered in the course of negotiations, legal fees will have been incurred every extended step of the way.

I have other, deeper, philosophical reservations about Class F common. In my experience as a startup lawyer, I often appeal to various constituents about the merits of a "common currency," one that aligns interests, those of founders, investors and employees alike, in the equity value of the company (value to be realized on an exit, or, in a "no exit" paradigm, in distributions to the equity holders). Rather than craft a version of common that acts like preferred, I think founders will better lead their companies by advocating for preferred stock terms that are simpler, with 1x preferences that do not bury the common.

I also think the Class F common feels defensive. At the end of the day, founders maintain appropriate control of their companies by being judicious about the terms of the investments they take, and the people or institutions or investment pools from whom they take investment. 

An entrepreneur (client) I admire wrote on his blog the other day about how easy it is to criticize the efforts of others. Mindful of that, I want to be sure to allow that there may be situations where control by a family, an inventor, or others should be given a premium value, and more time, effort and cost should be expended, not only to establish something like Class F common stock at the outset, but also to explain it to everyone (e.g., employees or others who may be compensated with the Class A common, the non-founder investors, and the non-super board members) at every turn in the venture's life cycle. Those explanations won't be cheap, however. Class F common ain't part of a bootstrapper's capital structure.