Since most investors willing to accept the high risks of investment in a startup wish to obtain the rewards derived from equity ownership, a common method of initial financing is through the sale of an equity security - common shares, preferred shares or convertible preferred shares. Since the common shares usually carry the full right to participate in earnings and thus increase proportionately in value as the startup grows in earnings and networth, common shares are the usual method of investment for the founders of a startup and sometimes the initial investors.
On the other hand, the initial investors may wish to own a security senior to the common shares insofar as liquidation and dividend preferences are concerned. Often preferred shares are sold to the investors with the right to convert such preferred shares into common shares. In addition, many venture capital funds require some income from their investment, particularly those funds that need investment income to defray the funds' operating costs. However, since most of new startups do not have the earnings to pay preferred stock dividends, payment of such dividends would constitute a return of capital rather than of earnings. The investors may accordingly be funding their own dividends until the startup has sufficient earnings to cover the dividends.
Convertible Preferred Shares
In addition to being commonly used for venture capital investors, convertible preferred shares might be used where there is a substantial difference in the price per share of equity securities issued to the founders as compared to that sold to the outside investors. Instead of issuing common shares, for example, at $10.00 a share to the founders, and $50.00 a share to the outside investors (which bargain element of $40.00 a share might be viewed as taxable compensation to the founders for services rendered, the startup could issue convertible preferred shares to the outside investors, convertible at $50.00 per share or, even up to $100.00 per share, without creating adverse tax consequences to the founders for having received common shares at $10.00 per share.
Hybrid Preferred Shares
These are preferred shares with provisions more common to debt securities, as for example, a provision allowing the holder to exchange the preferred into debentures, which are in turn convertible into common shares.
In most instances a contribution of property to a startup for shares may be structured to avoid taxation at the shareholder level. The potential adverse tax consequences referred to above result by virtue of the Income Tax Act, which treats a transfer of property (including shares) in connection with the performance of services as taxable compensation. Thus, the unrestricted receipt of shares by a founder in whole or in part for the performance of past or future services is taxable to the founder. Although not as clear, the receipt of a partnership interest for services may also result in compensation income. If a shareholder recognizes income on the receipt of shares for services, the amount taxable is the difference between the fair market value of the shares and the fair value of any consideration given for the shares. The amount is taxable at the time the recipient acquires a beneficial interest in the property, disregarding any restriction which by its terms will never lapse. An example of a non-lapse restriction is a requirement that the shareholder sell the shares back to the startup at book value on termination of employment. Another example is a permanent right of first refusal to the startup on sale of the employee's shares. Lapse restrictions that delay recognition of the income are restrictions that raise a substantial risk of forfeiture or that make the shares non-transferable. If the shares issued subject to a lapse restriction, the time of recognition of taxable gain occurs when the property is transferable or is no longer subject to a substantial risk of forfeiture. The fair market value is determined at the time of the lapse of restrictions and the amount of gain is based on that value.