As a startup founder or early employee, understanding the differences between preferred stock and common stock is crucial for making informed decisions about your company’s equity structure.
This guide will explore the key distinctions, benefits, and considerations associated with these two types of stock, providing you with valuable insights to navigate the complex world of startup financing and equity management.
Common stock represents basic ownership in a company and is typically issued to founders, early employees, and sometimes investors. It’s the foundation of a company’s equity structure and comes with certain rights and characteristics:
Many private companies use common stock option grants as a way to attract and retain talent. These grants give employees the right to purchase shares at a predetermined price, known as the exercise price. When an employee exercises their options, the company issues the corresponding number of common stock shares.
Preferred stock is a class of ownership that combines elements of both equity and debt. It’s primarily issued to investors, such as venture capitalists, angel investors, and private equity firms, during funding rounds. For a deeper dive into preferred stock, check out our comprehensive guide on preferred stock. Key features of preferred stock include:
Preferred stock is attractive to VCs because it offers greater control over the company than common stock. The additional rights and protections associated with preferred shares help mitigate the high risks inherent in startup investing while still allowing for significant upside potential.
It’s highly unusual for venture capitalists to purchase a security other than preferred. Founders sometimes negotiate special stock for themselves (see our section on founder’s preferred below), but typically the rest of the cap table (i.e. the employees who get options) are going to get common stock. If you want to learn about setting up a stock option plan, read our guide to ESOs.
To better understand the differences between these two types of stock, let’s examine their key characteristics:
To understand more about liquidation preferences and their impact, visit our guide on liquidation preferences.
Preferred stock plays a crucial role in startup financing, particularly during priced rounds. Here’s how it typically works:
When a startup raises what’s called a “priced round” it is almost always a sign that the company sold preferred, not SAFE or convertible notes.
Many early-stage startups use Simple Agreements for Future Equity (SAFEs) or convertible notes for initial funding. These instruments typically convert into preferred stock during a priced round, often at a discount to incentivize early investors. For more information on how SAFEs work in startup accounting, read our guide on SAFE notes accounting.
A recent innovation in the startup world is the concept of founder preferred stock. This new class of stock allows founders to receive a portion (usually 10-20%) of their equity as preferred stock instead of common stock. To learn more about this trend, check out our article on founder preferred stock. Key features include:
While this trend offers potential benefits to founders, it’s essential to consult with legal and tax professionals before implementing such a structure.
When dealing with preferred stock and common stock, founders should keep the following points in mind:
Understanding the differences between preferred stock and common stock is crucial for startup founders, employees, and investors alike. Each type of stock comes with its own set of rights, risks, and potential rewards. By carefully considering the implications of your equity structure and seeking professional advice when needed, you can make informed decisions that align with your company’s goals and set the stage for long-term success.
As your startup grows and evolves, remember that your equity structure will likely change as well. Stay informed about industry trends, keep open lines of communication with your investors and board members, and regularly review your capitalization table to ensure your equity strategy supports your company’s vision and objectives.
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