Preferred Stock

Start-up investors will usually make their investments in form of preferred stock. Preferred stock is equity, like common stock, except that the investors negotiate certain rights for themselves as a condition of their investment. These rights place preferred shareholders senior to common stockholders in their claims against the corporation, but still junior to debt.

A common theme in the jurisprudence that has developed around preferred stock is that the rights of preferred stockholders are contract rights. To the extent preferred stockholders have rights different than the rights of common stockholders, those rights are a result of negotiation between preferred stockholders and the corporation. Courts will not presume anything about the rights of preferred stockholders. If a preferred stockholder, particularly a preferred stockholder represented by sophisticated counsel, could have negotiated for a right, but sought not to, courts will not likely given preferred stockholders the benefit of the doubt. 

It is unremarkable that directors have fiduciary obligations to act to maximize the value of the corporation over the long-run for the benefit of residual claimants. Common stockholders are the residual claimants. To the extent preferred stockholders have rights that differ from the rights of common stockholders, boards do not have a fiduciary obligation to maximize the value of those rights, which are protected by the contract law. 

Where boards arrange transactions in order to maximize the payouts to preferred stockholders at the expense of the common stockholders, boards risk running afoul of their fiduciary duties. This risk is amplified when preferred stockholders are represented on the board of directors.