Common vs. Preferred Stock in Startups

Equity can be one of the most important assets for startups. Because of it’s potential upside, equity can help startups attract key talent and capital that otherwise might be drawn to more established companies capable of offering greater salaries and/or more predictable returns. While there are many ways structure equity compensation and investments, one of the key distinctions is the difference between common and preferred stock. 

What is the Difference Between Common and Preferred Stock?

Common stock and preferred stock both confer equity in a company and generally come with voting rights. Beyond voting, however, preferred stock generally has significant rights that common does not have. Specifically, preferred stock generally has features that protect investors in scenarios ranging from sales of new or existing preferred stock to a change of control or liquidation event. These rights can include a liquidation preference, participation rights, pre-emption rights, right of first refusal, co-sale rights and redemption rights.

Who Gets Which Kind of Stock

When early-stage startups issue equity, there are generally two classes of people receiving shares: employees or founders and investors. Employees and founders typically receive common stock. Investors, on the other hand, generally receive preferred stock.

Why Does the Common vs. Preferred Stock Distinction Matter?

When a company is sold, all shareholders have access to a portion of the proceeds, but the allocation of proceeds depends both on the percentage of the company held and the specific rights associated with the shares held. Because preferred stock often features rights that confer economic preferences as compared to common stock, the specific features of the preferred stock issued by a company can significantly impact the allocation of proceeds in a liquidation scenario. In certain cases, common shareholders may be left with little or no returns after the required payments to preferred shareholders, especially in cases with participating preferred stock or multiple liquidation preferences.

Non-Participating Preferred Stock vs. Participating Preferred Stock

Generally, holders of preferred stock receive preferential returns. This means that they are paid back their initial investment plus some preferential payment before any other proceeds are disbursed. The extent to which additional funds beyond this preference is paid out to holders of preferred stock depends on whether the equity is non-participating preferred stock or participating preferred stock.

Participating preferred stock takes a share of the proceeds from the deal along with common stockholders after receiving the preferential returns -- i.e., the preferred holder participates in the equity apportionment in addition to receiving its preference. Holders of non-participating preferred stock, however, only receive the preference plus any accrued dividends.

FAQ

Is there a way to secure investment without issuing preferred stock?

Generally investors ask for preferred stock, but in some cases investors may agree to receive common stock. Still, most investors insist upon preferred stock to protect their investment, especially when investing in a startup.

What are preemptive rights and who has them?

Preemptive rights allow common shareholders to maintain their proportional ownership in a company by buying more shares in the event that the company issues another offering. These are sometimes issued to holders of common stocks. Holders of preferred shares typically also have other protections against dilution.

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