Class B vs. Class P...where's class J?

February 29, 2012 7:50 AM

[Asking for a colleague] Question about share classes in terms of equity held in a start-up they used to work for. Differences between Class P and Class B, and implications of conversion.

Colleague says: "Let's say I own a small amount of Class B non-voting shares in a company that I used to work for. There are a small number of shareholders as the company is still privately held.

One of the small investors purchased Class P (preferred) non-voting stock but is now selling them to one of the larger investors. The Larger investor has apparently agreed with the CEO to change the class of the stock from Class P to Class B. The CEO has contacted me because he says that as a Class B stock-holder, he needs my permission. This surprises me but that's what he claims. His claim is that it would not dilute my share, as those stock already exist and that it would benefit me financially, as the third party stock holder is essentially agreeing to downgrade their stock. What are the implications of me either agreeing or not agreeing to this happening?"

posted by weaponsgradecarp to work & money (6 answers total)

You won't get an answer without reading the legal documentation. Stock purchase or grant agreements, the exchange agreement, corporate by-laws, etc. Many (all?) of the relevant terms involved are negotiated, so there's not a standardized answer to the question. Your colleague should hire a lawyer.
posted by mullacc at 8:18 AM on February 29, 2012

First, I am NOT an lawyer. So I could be entirely wrong about this.

That said, what I *think* is going on is...

Since it's a privately held company, the market for the stock is not fluid (you can't just sell your shares at a stock exchange) and having an existing shareholder buy shares from someone who wants out is usually the best arrangement. You have someone who already owns a fairly large amount of shares who is willing to buy out the other investor, but ONLY if the shares are converted from P to B. So the big issue is, what is the logic behind the conversion? How does this change the power held by the larger investor? Who is pushing for the stock change - is this something the CEO wants the larger investor to agree to, to keep the larger investor from having too much "preferred" stock? If the idea is that this allows the larger investor to own a bigger piece of the company but at a lower "preference" level stock to keep the bigger investor from gaining more "preferred" stock, it may be a good deal for everyone.

I would first ask the CEO for the story behind WHY they want to change the stock status. Then confer with an attorney to see if it makes sense.

You should have a good reason to refuse to agree with the CEO about this change. But you have an obligation to yourself and to the company to understand what they are proposing, to make sure you make an informed decision and not just go along because the CEO asks you to. That's one of the ideas behind having many people on the board, and owning stock, so that in addition to sharing the ownership they also share the responsibility of making decisions.

Also consider if YOU want out. Maybe you can offer to agree to the deal only if the larger investor buys out your shares too.
posted by jcdill at 8:42 AM on February 29, 2012

IAAL. IANYL. TINLA.

Stock class manipulation in a situation like this almost always has both the intent and the effect of stealing from the investors who are not involved in planning and executing the manipulation. That is, the company has some particular value (which is split up among the existing shareholders in some way) and some group of shareholders (or outsiders trying to become shareholders) want the value to be split up differently. Obviously, they rarely want to "split it up differently" in a way that benefits somebody other than them.

This can be somewhat legitimate: the exact value of a company is hard to pinpoint, and even if you could do it, the shares are probably not easily turned into money. So imagine someone considering investing $100k: he wants to get shares that seem -- to him -- to be worth at least that much. He might not want shares with no voting rights, or from the same pool as an existing shareholder. So the company might create a new class of stock that's what the investor wants to buy.

But that probably changes the value of the existing shares somehow, so the existing shareholders may need to be consulted (even if they don't normally get to vote).

You have to look at all the docs to figure out what's going on, and follow the money to see who's winning and who's losing. It's guaranteed that somebody is benefiting from the transaction, otherwise it wouldn't happen. A lawyer can help you figure out who, and by how much, and whether some of that benefit is being siphoned off from your shares.
posted by spacewrench at 10:05 AM on February 29, 2012

Stock class manipulation in a situation like this almost always has both the intent and the effect of stealing from the investors who are not involved in planning and executing the manipulation.

Simply not true and definitely not helpful.

There are probably quite valid reasons for the transaction. Basically this looks like a conversion of one shareholders stock from preferred down to what we call common. The CEO asserts that the total number of shares is not changing, in which case there is probably no significant effect on another holder of common stock. It's not uncommon for a shareholder vote to be required for these types of transactions - just so that everybody gets a chance to have their say and nobody gets ripped off. So I don't think you should be surprised about been asked to vote. Most shareholder votes require either a majority or sometimes a super-majority (say 66% or 75%) to pass. I'd be very very surprised if it had to be unanimous. In which case, unless your friend is a large shareholder their vote probably doesn't matter one way or the other. If on the other hand their vote can block the transaction then they should seek real legal advice over the implications of that action.
posted by Long Way To Go at 12:30 PM on February 29, 2012

Update (largely at jcdill):

The answer is that the CEO asked the large investor to change the class of the stock. The Class P shares are a reasonably small quantity. Almost all of the shares in the company are class A voting or class B non-voting. The large investor previously owned only class B non-voting stock. The CEO owns Class A. I own a small amount of Class B non-voting. There really isn't a functioning board. The board consists of the CEO and one of the early investors, both of whom own class A voting stock.

Just to add confusion, the large investor who has agreed to downgrade their stock is the father of the second board member. According to the CEO, the CEO asked the large investor to change the class of the stocks so that they are 'paid at the same time' and 'be on an equal footing' and the large investor agreed 'just to be nice'.

The follow-up question that I have is what specific documents should I ask the CEO for, so that I can review them? Also, what documents is the CEO legally required to show me?
posted by weaponsgradecarp at 11:17 AM on March 1, 2012

So it looks like this is a way for the CEO to get rid of the Class P shares completely - basically simplifying the stock structure of the company. It really looks like the large investor is doing the CEO a favor. The Class P shares most likely have a lot of rights that the Class B don't, so it typically wouldn't be in the large investors interest to convert, especially one for one (i.e. one share of P becomes one share of B). I'm speculating, but most likely not having the Class P would make any sale or change of control of the company easier - usually the Class P would have extra rights giving them extra control over those types of transactions. So the net effect I'm guessing is that the CEO will have more control over what happens to the company basically by removing the small investor with Class P and getting the large investor to give up those rights.

I can't say for sure what docs you should ask for, whatever the company has that specifies the rights of each class of stock. For my company that would be the Articles of Incorporation, the Voting Agreement and the Investors Rights Agreement. I would ask for "all pertinent" documents. However, as an existing holder of Class B stock I wouldn't be too pushed about the transaction unless I felt that the small investor had been acting in my favor against the CEO and the large investor by exercising their Class P rights. Then I would be worried about losing my "protector". This sounds like a pretty unlikely scenario so I wouldn't be bothered about the Class P going away. I have no idea what the CEO is legally required to show you. You would have to ask a lawyer for an opinion.
posted by Long Way To Go at 2:03 PM on March 1, 2012