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Every Delaware general corporation must have one class of common stock, but it can have more than one class of stock, with different rules for the different classes. The most popular second class of stock is called “preferred stock” because it contains terms that are preferred over the rights of common stockholders. Delaware’s brand of preferred stock is so powerful and flexible a business tool, it is commonly called "blank check preferred stock."
Common stock has two characteristics that are written in the law and they are mandatory. The first is that every share of common stock carries one vote. If you own 100 shares you have 100 votes to vote on all matters presented at stockholder meetings. The second is the right to your pro-rata share of any dividends issued by the directors to the common stockholders. If the total dividend is $1,000,000 and you own 10 percent of the total outstanding shares, you’re entitled to 10% of the million dollars. Common shareholders own the company and they have a right to share in the profits. That’s fair.
But the board of directors, with shareholder approval, can authorize a second class of "preferred stock" (aka blank check preferred stock) that can be issued by the board to attract capital, top people, or strategic alliances. The total number of shares of preferred stock may be split into any number of different “series” of the preferred stock, each series having its own separate terms. For example, the company may be created with 1,000,000 shares of common stock and 100,000 shares of preferred stock. The board can designate that the preferred be split into 10 series numbered one through 10 of 10,000 shares each, and that the terms of each series can be negotiated separately and are independent of the other series.
What’s preferred about blank check preferred stock? First, voting rights. Common shareholders get one vote per share, but you can give one or more series of the blank check preferred stock super voting power like two votes per share, or 10 or 100 or 1,000 votes per share. Why do this? Let’s say you’re creating a series of preferred stock to option out to key personnel. You can offer company insiders voting power this way. Or let’s say you are attracting capital from a key shareholder that already owns a big percentage of your common stock and you don’t want him to take control. So you create a series of preferred stock with no voting rights, but a guaranteed 10% dividend paid quarterly. Your investor might be enticed to invest more money but give up any increased voting rights. Or let’s say you are raising capital and you’ve sold 45% of your stock. Once you sell more than 50% of the company, you lose control. So what do you do? Bring out a series of preferred stock designated as "founder’s stock" in which the 10,000 shares have 100 votes per share. Have the board of directors issue the whole 10,000 shares to you. Now you can sell more of the common stock to investors and still keep control of the company. These maneuvers are sophisticated tricks and should be undertaken with the assistance of a really good corporate lawyer, obviously.
Secondly, blank check preferred stock can have a preferred dividend over common stock. Preferred stockholders can be guaranteed a certain dividend per share ($1.00 per share, for example) or a dividend based on a business calculation that suits the deal, (x% of increase in net profits, for example). These dividends can be guaranteed, cumulative, and convertible to common stock if the deal makers agree on it and a good lawyer drafts it up right. Preferred dividends are usually paid before the common stockholders see any return.
Third, blank check preferred stock can hold a security interest in a company-owned asset. This can include a patent, real estate, a major piece of equipment, or any other company asset. Let’s say your company owns a patent that is much more valuable when combined with another patent that you don’t own. Negotiating with the owner of that patent might be a breeze if you could design a series of preferred stock with no voting rights but a security interest in your patent and a royalty from sales of the products that contain their patent. (Or whatever you can dream up). Or let’s say the company is desperate for an influx of cash. Bankruptcy is the next step if a deal isn’t put together in time to save the company. No one will buy your common stock if you’re about to go bankrupt, but someone might invest if you gave them a security interest in the assets that will be freed up if the company goes bankrupt. I hope you never need to use that technique, but if you find yourself in that position you’ll be glad you have a Delaware corporation with blank check preferred stock.
If you’re just about to form your Delaware general corporation and expect to sell stock in the company to raise money, it would be a good idea to consider getting the preferred stock right from the start by including it in the certificate of incorporation. That way you won’t need the shareholders' approval to authorize it when the time comes that you need it. The directors will be able to issue the stock in the best interests of the company without the necessity of getting shareholder approval. If you already run a Delaware general corporation, you will need shareholder approval to amend the certificate of incorporation authorizing the preferred shares. If you control the common stock now, it would be a good idea to authorize this class of stock at your next shareholder meeting so that when you need it, it’ll be there.
THE AUTHOR OF THIS BLOG ARTICLE IS NOT A LAWYER AND HARVARD BUSINESS SERVICES, INC. IS NOT A LAW FIRM. THE ARTICLE ABOVE IS NOT INTENDED AS LEGAL ADVICE AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. THIS SHORT ARTICLE IS STRICTLY TO MENTION SOME ASPECTS OF DELAWARE’S CORPORATION LAWS AND/OR LAWS RELATING TO OTHER FORMS OF ENTITIES WHICH YOU MAY NOT BE FAMILIAR WITH. WE RECOMMEND THAT YOU CONSULT WITH A LAWYER BEFORE FORMULATING A STRATEGY WHICH WILL BE SUITABLE FOR YOUR SPECIFIC CASE.