Common vs Preferred Stock in a Startup: What You Should Know
Funding is the lifeblood of any startup, and as your business grows, you’ll need to raise money to continue scaling. Issuing common stock and preferred stock at different funding stages is the best way to acquire the capital you need.
Before you start compiling a list of potential investors, you’ll research the various types of equity. You’ll also find out how the ownership status works, the voting rights you’ll cede, and the expected profit sharing. This article will look at the difference between common vs preferred stock in a startup.
Let’s Understand What Common Stock Is
Common stock is the company equity listed on a registered stock exchange. This equity is open for investors in the open market and represents a share of company ownership. Startup founders retain common stock to maintain voting rights which they can use to make critical decisions that influence operations.
Common shareholders have the right to elect the board of directors and may allot shares to employees as part of ESOPs. Such Employee Stock Option Plans (ESOPs) incentivize team members to work for the company’s success, and Founders typically offer them as part of their salary packages.
Market conditions can affect stock trading, and share values appreciate or depreciate accordingly. But, as a rule, common stock is cheaper than preferred stock since it doesn’t come with rights and other privileges.
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How Preferred Stock Works
Venture capitalists, angel investors, and other private entities wishing to fund your company typically want to negotiate for preferred stock. This form of stock is a desired or particular class of shares since they confer certain rights on the holders. When entrepreneurs offer preferred stock, they also ensure preferred treatment for their investors. Here’s how:
- Investors may purchase preferred shares or other options like convertible notes or SAFEs. A Simple Agreement for Future Equity (SAFE) is a contract between the founder and investor. This contract outlines terms and assures the investor of receiving equity in case of certain triggering events like qualified financing.
- Preferred stockholders receive dividend payouts before profit-sharing reaches common stockholders.
- If the startup fails, preferred stockholders can expect to receive liquidation preferences on priority over common stakeholders.
However, be mindful that both common vs preferred stock in a startup carry similar risks for their owners.
Additional Differentiators Between Common vs Preferred Stock in a Startup
The key difference between common vs preferred stock in a startup is that founders and employees get common stock. Workers may receive Employee Stock Option Plans (ESOPs) or the option to buy common shares in the company.
When entrepreneurs are looking for funding and pitch to investors, they may offer preferred stock for their investment. Both options confer a form of ownership on their holders, along with voting rights on selected company issues. The objective behind issuing preferred stock is to offer added protection to the investors in case of various future scenarios. These may include:
- The startup’s management and ownership change hands;
- Founders sell the startup by way of an acquisition or merger;
- Founders liquidate the company and sell the assets piecemeal;
- Further Series A, B, C, and D funding rounds lower the company’s value;
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What Happens in Case the Company Fails and Liquidates
If the founders sell the startup, preferred stockholders get liquidation benefits over common stockholders. Of course, these benefits are clearly mentioned in the investment contract. Here are some of them:
- In most liquidation events, preferred stockholders receive priority distribution equivalent to their investment or 1x. However, some startup owners may confer a distribution higher than 1x to the investors when raising funds. If they offer 1.5x or 2x distributions to investors, common stockholders could get a lower portion of the sales proceeds.
- When the company liquidates, preferred stockholders can receive priority payments. But they also have the option to convert their preferred stock into common stock or an ownership stake. Investors can exercise their conversion right if the common stock has a higher value in the open market. Conversion rights clauses in the investment agreement specify the expected date and ratio of conversion.
- Preferred stockholders can convert their shares into common stock if the startup has an Initial Public Offering (IPO). Or if another company acquires the startup.
- Preferred stock can be participating or non-participating. In the case of non-participating stock, founders honour payments to common stockholders after distributing payments to preferred stockholders. However, if the preferred stockholders are “participating,” they can “double dip” or get a share in the distributions allocated to the common stockholders.
Founders should be cautious when issuing common stock and preferred stock because, in case of liquidation, common stockholders could receive only minimal returns.
Additional Rights for Preferred Stockholders
When raising funding, founders may choose to offer additional rights to investors. Here are some of them and how they work.
Pro-Rata Investment Opportunity
Consider the pro-rata investment opportunity as an additional benefit you could offer preferred stockholders. Typically, startups raise funding in several funding rounds, such as pre-seed, seed, Series A, B, C, and further rounds. With each new issue of preferred stock, investors may lose some of their rights and ownership stake in the company.
Pro-rata investment opportunity offers holders the right to buy more shares in the subsequent funding round to maintain their ownership percentage. This provision helps safeguard investors’ interests by maintaining their proportional ownership. You can choose to offer this preemptive right as part of the preferred stock conditions when accepting funding from the investors. However, this right applies to a single subsequent funding round, not to all later rounds.
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Anti-Dilution Rights
Before raising any funding round, startups must go through the valuation process. Let’s assume that the company had a higher value when your investors offered funding. However, post-money valuation could be lower during subsequent funding rounds per market conditions and performance.
If that happens, previous stock holdings might get diluted. Your investors might want protection from this risk by requesting anti-dilution provisions with their preferred stock. These rights confer the right to buy additional shares in the startup in case of a down round. Using this provision, investors can ensure that their percentage of ownership interest in the company remains unchanged. This is one of the most important and key differences between common and preferred stock in a startup.
Right to Information
Depending on the terms and conditions of the investor contract, founders may provide detailed data to preferred shareholders. This data may include information like the company’s financial status and operations progress. Typically, this right is part of the agreement with major holders or preferred stockholders who invest large sums of money. Like, for instance, half a million dollars or more in the startup.
Right to First Refusal
The Right of First Refusal (ROFR) is typically awarded to venture capitalists who invest in a startup. If anyone from within the company wants to sell stock, they must first approach the venture capitalist. This seller could be an executive team member, common stockholder, or preferred stockholder.
Since VCs are professional investors, they retain the right to raise their ownership stake. However, as the founder, you always have the option to deny this right. That’s because a ROFR could mean ceding additional information and controlling power to the investors.
Protective Provisions
Venture capitalists may require founders to award them protective provisions with their preferred stock. These provisions allow them to veto specific corporate decisions impacting their stake in the company. You can grant them added rights depending on your negotiations with the investors. These rights may include voting to elect outsiders or some investors on the board of directors.
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Co-Sale Right
Also termed tag-along rights or take-me-along rights, the co-sale right is typically exercised by minor preferred shareholders. Accordingly, minor holders get the same deal whenever the founder or company owners sell some of their stock. So, for instance, if you sell some of your common stock for $50 per share, your investors get the same deal. The co-sale right is typically paired with the ROFR clause.
Redemption Rights
Redemption rights are rarely exercised, but venture capitalists may require the startup to buy back its shares. Most investor agreements don’t allow investors to exercise this right five years from the funding date.
However, preferred stakeholders may demand redemptions if the company is not performing well. Or is an unsuitable candidate for an acquisition or IPO? The redemption amount is equivalent to the original investment amount and includes accrued dividends not yet paid.
Companies Have Both Common Stock and Preferred Stock
Startup founders issue both common and preferred stock, using the latter option to acquire crucial funding for the company. However, you should remember that offering preferred stock will entail ceding certain rights and privileges.
You’ll take the time to understand how the rights work and the expected impact on your new company. Also, negotiate the terms aggressively and accept funding only on the conditions suitable for you. And your vision for the future of the startup.
