Everyone is aware of the dramatic growth and success attributed to companies such as Uber and Snapchat. However, not everyone may be aware of the structures used by those companies that allow for such development and progress. We did the heavy lifting for you and compared certificates of incorporation of five leading unicorns: Facebook, prior to its IPO, Palantir, Snapchat, Uber, and AirBnB.
Our findings have revealed that key to the anatomy of the unicorns lay in similar founder preferences and down road economic protections for the companies’ investors. We will briefly discuss these founder and investor preferences, as found in the certificates of incorporation.
A unicorn tends to have a founder-friendly anatomy. This is accomplished by giving founders economic and liquidity rights, but most importantly by giving the founders control rights (within provisions on voting and director selection). A way of maintaining founder control of the company is for the company to issue two classes of common stock, with certain voting privileges for the founders or conversely, imposing limitations on voting for investors.
Issuing two classes of common stock allows the founders to avoid dilution when the company acquires more and more stockholders and ensures that their votes hold more weight in the decision-making process. Generally, the voting rights of holders of class B common stock are increased by granting them 10 votes per share.
The common stockholders are also given more board representation, with the ability to elect the majority of its members. This is a method of ensuring that the directors chosen by investors may be outvoted and thus the interests of the company and founders will be protected, rather than the interests of the investors. In the case of Uber, the common stockholders even elect six directors.
Alternatively, instead of common stock, the founders are given a founder preferred stock. This gives the founders the option to later convert to a series preferred stock and enjoy the liquidity preference along with the preferred stockholders that series.
Investors are generally offered strong liquidation preferences and priority in receiving dividends. At the same time, since unicorns tend to have multiple financing rounds, there is much discussion over priority among the investors themselves as to who will get paid first. The general practice on dividend disbursement is to pay the investors on a pro rata basis, however, as in the case of Palantir, sometimes there is a stack priority present. A stack priority essentially means investors will get paid in the order of who invested the latest. For example, in Palantir, the Series K preferred stockholders are paid first, then the Series J, and so on, with the common stockholders situated on the bottom of the stack.
In some instances, investors are given dividends in the amount of a percentage of the original issue price, meaning their original investment amount in the round per share of preferred stock. In the case of AirBnB, it’s 8% of the original issue price, for Snapchat – 6%. In all cases, the dividends are all non-cumulative.
Upon the occurrence of a liquidation event, investors are generally paid out an amount per share equal to the original issue price per share plus any declared but unpaid dividends. Less frequent is the use of a multiplier, which gives the investor, or holders of certain series of preferred stock, x times the original issue price per share. For instance, the Series C-2 and C-3 preferred shareholders of Uber are granted a 1.25x multiplier. All companies opted for the standard, non-participating preferred liquidation preference.
The norm for the unicorns is a broad-based weighted average anti-dilution provision. Investors are also not granted redemption of their preferred shares, except in the case of Palantir, where redemption is possible for the Series H preferred stock. AirBnB, on the other hand, has a specific price reduction provision regarding conversion of Series C preferred stock.
All five of the companies offer auto conversion mechanisms upon the closing of an initial public offering. The shares will convert into class B common stock on the most part, for some of the companies they convert into class A common stock.
To ensure their effective functioning, the unicorns will usually impose limitations on the investors’ right of control. For instance, the amount of directors on the board of directors elected by the investors varies from one to two members, as opposed to two to six elected by the common stockholders.
At the same time, certain investors are granted more voting rights than others. Some of the preferred series are granted 10 votes per share as-converted to the class B common stock (as in Uber or Palantir), others are granted 1 vote per share as-converted.
Snapchat, on the other hand, has gone about limiting its investors’ right of control by completely taking certain series out of the voting process. We stress, however, that this is a unique and very rarely utilized way of curbing investor control over a company and one that we do not come across in practice.
Permitted Secondary Transactions for Class B
Although the holders of the class B common stock are not offered the preferential rights of the preferred stock, such as the anti-dilution protection or the liquidation preference, some of the unicorns give them the option to transfer their shares to a third party. This is usually a trust for the benefit of the stockholder, the stockholder’s family member or an entity owned by the stockholder, or a direct transfer to such affiliated entity. Uber’s COI includes that the shares may be transferred by will or intestate succession.
From the five unicorn anatomies we have looked at, Snapchat’s is the most unusual, with some non-standard provisions that make it certainly the most founder-friendly of the bunch. Firstly, it does not give its series C, D, E, F preferred shareholders any voting rights, essentially allowing them to just invest and tag along for the ride. Furthermore, the investors are not granted anti-dilution protection and therefore may likely lose their respective ownership percentages. Lastly, Snapchat allows for the series Founder Preferred shareholder to elect to auto convert their stock into class A common stock.
Stay tuned for the second post of this unicorn anatomy series where we will present a table comparing the key similarities and differences between the five unicorns along with a advice on how to structure your Certificate of Incorporation in order to increase your chances of joining the unicorn club.