venture capitalists (VCs)
Providers of venture capital;
typically, formal businesses
that maintain strong oversight
over the firms they invest in and
that have clearly defined exit
strategies.
314 PART 2 Important Financial Concepts
noncumulative preferred stock
Preferred stock for which passed
(unpaid) dividends do not
accumulate.
conversion feature
(preferred stock)
A feature of convertible pre-
ferred stockthat allows holders
to change each share into a
stated number of shares of
common stock.
venture capital
Privately raised external equity
capital used to fund early-stage
firms with attractive growth
prospects.
- Most preferred stock is cumulative, because it is difficult to sell noncumulative stock. Common stockholders obvi-
ously prefer issuance of noncumulative preferred stock, because it does not place them in quite so risky a position.
But it is often in the best interest of the firm to sell cumulative preferred stock because of its lower cost.
Most preferred stock has a fixed dividend, but some firms issue adjustable-rate (floating-rate) preferred stock
(ARPS)whose dividend rate is tied to interest rates on specific government securities. Rate adjustments are com-
monly made quarterly. ARPS offers investors protection against sharp rises in interest rates, which means that the
issue can be sold at an initially lower dividend rate.
must be paid before dividends can be paid to common stockholders. If preferred
stock is noncumulative,passed (unpaid) dividends do not accumulate. In this
case, only the current dividend must be paid before dividends can be paid to com-
mon stockholders. Because the common stockholders can receive dividends only
after the dividend claims of preferred stockholders have been satisfied, it is in the
firm’s best interest to pay preferred dividends when they are due.^1Other Features Preferred stock is generallycallable—the issuer can retire
outstanding stock within a certain period of time at a specified price. The call
option generally cannot be exercised until a specified date. The call price is nor-
mally set above the initial issuance price, but it may decrease as time passes.
Making preferred stock callable provides the issuer with a way to bring the
fixed-payment commitment of the preferred issue to an end if conditions in the
financial markets make it desirable to do so.
Preferred stock quite often contains a conversion featurethat allows holders
of convertible preferred stockto change each share into a stated number of shares
of common stock. Sometimes the number of shares of common stock that the
preferred stock can be exchanged for changes according to a prespecified formula.Issuing Common Stock
Because of the high risk associated with a business startup, a firm’s initial financ-
ing typically comes from its founders in the form of a common stock investment.
Until the founders have made an equity investment, it is highly unlikely that oth-
ers will contribute either equity or debt capital. Early-stage investors in the firm’s
equity, as well as lenders who provide debt capital, want to be assured that they
are taking no more risk than the founding owner(s). In addition, they want con-
firmation that the founders are confident enough in their vision for the firm that
they are willing to risk their own money.
The initial nonfounder financing for business startups with attractive growth
prospects comes from private equity investors. Then, as the firm establishes the
viability of its product or service offering and begins to generate revenues, cash
flow, and profits, it will often “go public” by issuing shares of common stock to a
much broader group of investors.
Before we consider the initial publicsales of equity, let’s review some of the
key aspects of early-stage equity financing in firms that have attractive growth
prospects.Venture Capital
The initial external equity financing privately raised by firms, typically early-
stage firms with attractive growth prospects, is called venture capital.Those who
provide venture capital are known as venture capitalists (VCs).They typically are