Common vs Preferred Stock for startups?

[machine]

Doing some research on Common vs Preferred stock as it seems that with the S corp that I want to start soon I cannot have both. Interested in hearing any feedback from people who have went one way or another, amounts etc. Not looking for legal advice, just your own life in the trenches experience.

This will start out as a mechanical engineering R&D, prototyping company. Myself and my son initially and gonna take it real slow, might be years before we get up to full speed. Probably will want to keep it a small less then 10 person operation. I want to have some financing options down the road maybe or stock option stuff to offer. Right now leaning towards preferred.

[ArcSine]

Yeah, the S Corp single-stock-class rules effectively snuff out any attempts at getting creative in the equity section of the balance sheet. A couple of small differences in share rights are allowed as I recall, but you're pretty much limited to a homogeneous "all for one and one for all" structure across your outstanding shares.

Have you considered an LLC structure as an alternative? No S-Corp-ish prohibitions on multiple equity classes, while still delivering the pass-through tax benefit of an S Corp.

One thing of note, though, with respect to one of the two potential uses for pfd equity to which you alluded (outside financing). Preferred equity is pretty common in this arena, especially if dealing with professional financiers (VCs, PE funds, angels, ...). However, some--not all--of these types are still uncomfortable with the notion of taking customized, fancy pants variations of LLC member units. Corporate laws have been around a lot longer than LLC statutes, and so it's easier to predict how corporate pfd shares will behave in distressed scenarios (bankruptcy, default, missed performance targets, governance disputes, etc.), and when you're bankrolling a closely-held company that kind of predictability is appealing. So depending on where your money is flowing in from, you might hafta set up (or switch out to) a C-corp.

Just make sure your objectives couldn't be met just as well with simpler mechanisms, such as subordinated debt (for outside financing) and performance-linked bonuses (for employee incentives). Not to wet-blanket the preferred equity idea, just to suggest giving consideration to the simpler structures first, then moving on to pfd equity possibilities if the simpler stuff just won't get it done.

That said, though, I've seen plenty of situations where the second- (and third-) equity class idea was used to great benefit in effectively allocating risks, rewards, incentives, control, and cash flow in an optimal arrangement. So certainly keep the idea under consideration as you move forward with your new venture. Best of success with it!

[Freelancier]

Something else to consider: the selection of the type of business structure you make today does not mean you can't change it in the future pretty easily. Talk with a local small business attorney to understand how easy it is to change between structures in your location.

[machine]

Yeah, the S Corp single-stock-class rules effectively snuff out any attempts at getting creative in the equity section of the balance sheet. A couple of small differences in share rights are allowed as I recall, but you're pretty much limited to a homogeneous "all for one and one for all" structure across your outstanding shares.

Have you considered an LLC structure as an alternative? No S-Corp-ish prohibitions on multiple equity classes, while still delivering the pass-through tax benefit of an S Corp.

One thing of note, though, with respect to one of the two potential uses for pfd equity to which you alluded (outside financing). Preferred equity is pretty common in this arena, especially if dealing with professional financiers (VCs, PE funds, angels, ...). However, some--not all--of these types are still uncomfortable with the notion of taking customized, fancy pants variations of LLC member units. Corporate laws have been around a lot longer than LLC statutes, and so it's easier to predict how corporate pfd shares will behave in distressed scenarios (bankruptcy, default, missed performance targets, governance disputes, etc.), and when you're bankrolling a closely-held company that kind of predictability is appealing. So depending on where your money is flowing in from, you might hafta set up (or switch out to) a C-corp.

Just make sure your objectives couldn't be met just as well with simpler mechanisms, such as subordinated debt (for outside financing) and performance-linked bonuses (for employee incentives). Not to wet-blanket the preferred equity idea, just to suggest giving consideration to the simpler structures first, then moving on to pfd equity possibilities if the simpler stuff just won't get it done.

That said, though, I've seen plenty of situations where the second- (and third-) equity class idea was used to great benefit in effectively allocating risks, rewards, incentives, control, and cash flow in an optimal arrangement. So certainly keep the idea under consideration as you move forward with your new venture. Best of success with it!
I have mulled over going LLC instead, in trying to prepare for the greatest array of possible business scenarios I came to the conclusion I liked the S corp better. For instance if we wanted to attract someone to run the company or if we needed serious financing to pull off a big project such as manufacturing something. There stands a good chance I won't want to run things behind the desk, I am more of in the shop kind of guy. I don't know if business management is my sons strong suite or desire either.

Hopefully we never need financing of any kind, haha.

[machine]

Something else to consider: the selection of the type of business structure you make today does not mean you can't change it in the future pretty easily. Talk with a local small business attorney to understand how easy it is to change between structures in your location.
Just trying to avoid having to make changes down the road. I am a hardcore diyer, to a fault really but I am going to do my best to avoid attorneys and such.