Preferred Stock vs. Common Stock: A Comprehensive Guide for Startups
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 vs Preferred stock - video overviews
What is common stock?
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:
- Voting rights: Common stockholders can participate in key company decisions, such as electing board members.
- Potential for appreciation: If the company’s value increases, common stock can provide significant returns.
- Last in line for payouts: In liquidation events, common stockholders are paid after preferred stockholders and other creditors.
Common stock for employees
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.
What is preferred stock?
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:
- Priority in liquidation: Preferred shareholders have a higher claim on company assets than common stockholders.
- Special rights: VCs negotiate for (typically standard) rights, such as voting privileges, anti-dilution protections, or board seats.
- Convertibility: Often can be converted to common stock under certain conditions, such as an IPO - usually at moments that are good for the investor.
Preferred stock and investor appeal
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.
Comparing preferred stock vs. common stock
To better understand the differences between these two types of stock, let’s examine their key characteristics:
Price and valuation
- Common stock: Usually sold (or granted via options) at fair market value, with potential for higher capital gains.
- Preferred stock: Typically sold at a higher price based on company valuation and liquidation preferences.
Liquidation preference and payouts
- Common stock: Lower priority in liquidation events. Shareholders may receive payouts only after preferred stockholders and creditors are paid.
- Preferred stock: Higher priority in liquidation. Shareholders have a better chance of recovering their investment in case of bankruptcy or acquisition.
To understand more about liquidation preferences and their impact, visit our guide on liquidation preferences.
Voting rights and control
- Common stock: Generally comes with voting rights on important company matters, such as electing the CEO.
- Preferred stock: May come with special voting privileges or protections, such as the ability to vote as a class and block an exit or fundraise, or the right to get their pro rata share in a subsequent round.
Risk and long-term performance
- Common stock: Higher risk but potential for greater long-term appreciation if the company succeeds.
- Preferred stock: Lower risk due to liquidation preference and other protections, but potentially limited upside compared to common stock.
Dividend income
- Common stock: Dividends are not guaranteed, especially in venture-backed startups focused on growth.
- Preferred stock: May come with guaranteed dividends or priority in dividend payments.
The role of preferred stock in startup financing
Preferred stock plays a crucial role in startup financing, particularly during priced rounds. Here’s how it typically works:
- Valuation: The company and investors negotiate a valuation, which determines the price per share of preferred stock. This is not the valuation of the common, which is determined by a 409a.
- Investment: Venture capitalists and other investors purchase preferred shares at the agreed-upon price.
- Rights and terms: The preferred stock comes with specific rights and terms, such as liquidation preferences and conversion rights.
- Future rounds: As the company grows and raises more capital, new series of preferred stock (Series A, B, C, etc.) may be issued with different terms.
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.
Conversion of SAFEs and 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.
Founder preferred stock: a new trend
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:
- Converts to preferred stock when sold to investors in subsequent rounds
- Granted with full vesting upon issuance
- Not subject to repurchase or forfeiture if the founder leaves the company
While this trend offers potential benefits to founders, it’s essential to consult with legal and tax professionals before implementing such a structure.
Considerations for startup founders
When dealing with preferred stock and common stock, founders should keep the following points in mind:
- Understand the impact on ownership and control: Carefully assess how issuing preferred stock will affect your control over the company and future profit distribution.
- Negotiate terms wisely: Work with experienced attorneys to negotiate favorable yet fair terms for both parties.
- Consider long-term implications: Evaluate how preferred stock terms might impact future fundraising rounds and company valuation.
- Prepare for due diligence: Ensure your financial records and books are in order, and make sure you are correctly accounting for preferred stock, as investors will scrutinize this information.
- Manage your cap table actively: Use quality cap table software and regularly review your equity structure to make informed decisions about stock issuance and option grants.
- Balance valuation with terms: Be cautious about trading more favorable terms for a higher valuation, as this can have long-term consequences for your company.
Conclusion: navigating the complexities of startup equity
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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