Common Stock: Understanding Its Role in Startups and Venture Capital

While both types of shares represent ownership in the company, they come with different rights and privileges that can significantly impact the holder’s position in various scenarios. You can read our article on common vs preferred here, or below is a tldr version:

Common Stock: The Foundation of Startup Ownership

Common stock is typically held by founders, employees, and sometimes early-stage investors. It represents the most basic form of ownership in a company. Founders and early employees usually receive common stock as part of their initial compensation package or through stock option plans.

Key characteristics of common stock include:

1. Voting rights: Common stockholders can participate in major company decisions through voting.
2. Potential for high returns: If the company succeeds, common stock can appreciate significantly in value.
3. Lower priority in liquidation: Common stockholders are last in line to receive assets if the company is liquidated.

Preferred Shares: The Investor’s Choice

Preferred shares are typically issued to venture capital investors and come with additional rights and protections. These shares are called “preferred” because they often have preferential treatment over common stock in certain situations.

Key features of preferred shares include:

1. Liquidation preference: Preferred shareholders often have the right to receive their investment back before common stockholders receive anything in a liquidation event.
2. Conversion rights: Many preferred shares can be converted into common stock, usually at the time of an IPO or acquisition.
3. Anti-dilution protection: This feature helps protect investors from dilution in future funding rounds.
4. Dividend rights: Preferred shareholders may have priority in receiving dividends, if any are declared.

Recognition and Valuation

Common stock should be recognized on its settlement date, which is typically the date when the proceeds are received and the shares are issued. The stock is generally recorded at its fair value, which is usually the amount of proceeds received.

Allocation of Proceeds

When recording the issuance of common stock, the proceeds are allocated as follows:

1. Par value: First, the par value of the shares (if any) is recorded.
2. Additional paid-in capital: Any excess over par value is allocated to additional paid-in capital.

Determining the fair value of common stock can be challenging, especially for startups that are not publicly traded. However, accurate valuation is crucial for various reasons, including:

1. Issuing stock options to employees
2. Complying with accounting standards
3. Preparing for future funding rounds or exit events

ASC 820 and Fair Value Measurement

When estimating the fair value of common stock, companies should follow the guidance in ASC 820, Fair Value Measurement. The startup will hire a licensed 490a valuation provider, and they will use a variety of methods to come up with the company’s common stock price (which will be a lot less than the preferred share price). This standard provides a framework for measuring fair value and requires companies to consider various factors, including:

1. The company’s financial condition and operating results
2. The rights and preferences of the common stock
3. Market conditions and industry trends
4. Recent transactions involving the company’s stock

Common Stock Issuance Costs

When issuing common stock, companies incur various costs that need to be accounted for properly. These costs typically include:

1. Legal fees
2. Accounting fees
3. Fees paid to bankers or underwriters (startups won’t have this usually!!)
4. Other third-party expenses

It’s important to note that certain period costs, such as management salaries or general administrative expenses, are not considered issuance costs.

Accounting Treatment of Issuance Costs

According to SAB Topic 5.A, common stock issuance costs are generally recorded as a reduction of the share proceeds. This means that the net proceeds from the stock issuance are reduced by the amount of these costs.

Early-Stage Considerations

When a startup first gets going, the founders usually get common stock. It’s crucial to file an 83(b) election with the IRS to lock in this low price for tax purposes. Sometimes founders will sell common as what is called a secondary; so get your tax basis all buttoned up right away.

The Convergence of Common and Preferred Stock

As a startup approaches a liquidity event, such as an IPO or acquisition, an interesting phenomenon occurs: the value of common stock and preferred shares begins to converge. This convergence happens because:

1. The company’s success reduces the risk for all shareholders.
2. The likelihood of preferred shareholders exercising their special rights (like liquidation preferences) decreases.
3. Many preferred shares automatically convert to common stock upon an IPO.

IPO and Common Stock

During an Initial Public Offering (IPO), several important changes occur with regard to common stock:

1. Preferred shares typically convert to common stock.
2. All shareholders now own the same class of stock.
3. The stock becomes publicly traded, providing liquidity for all shareholders.

Here’s how it works:

1. Stock option pools: Companies set aside a portion of their common stock for employee stock options.
2. Vesting schedules: Options typically vest over time, incentivizing employees to stay with the company long-term.
3. Upside potential: The potential for significant financial gain if the company succeeds can be a powerful motivator for employees.

Founder Preferred Stock: A Special Case

In some cases, founders may be issued a special class of stock known as founder preferred stock. This hybrid between common and preferred stock can provide founders with some of the protections typically reserved for investors while maintaining their alignment with other common stockholders.

Talk with your attorney about this to get the guidance you need; not all VCs appreciate this type of a capital structure.