Common Stock Vs Preferred Stock

When it comes to equity in a company, not all shares are created equal. 

Businesses often issue two main types of shares: preferred and common. 

While both represent ownership in a company, they come with distinct features, benefits, and risks that cater to different kinds of stakeholders. 

What is common stock?

Common shares, also known as common stock, represent equity ownership in a company. When you purchase common shares, you acquire proportional ownership and a claim to the company's profits and assets. 

Shareholders of common stock typically have voting rights, allowing them to influence major corporate decisions such as electing board members or approving mergers.

However, they represent the most basic type of ownership in companies.

Who is it for?

Founders: Founders typically hold a significant portion of common shares as the original owners of the company.

Employees: Companies frequently offer common shares through Employee Stock Option Plans (ESOPs) and other forms of equity compensation to their employees.

Advisors: Advisors are typically granted advisory shares, which are a type of common stock, through stock options or RSAs.

Features of common stock

1. Voting rights

Shareholders of common stock typically have the right to vote on important corporate matters. This may include decisions like electing the board of directors or approving mergers.

2. Residual claims

In the event of liquidation, common shareholders are entitled to the company’s remaining assets after creditors, and preferred shareholders have been paid.

3. Stock splits

Companies may split common shares to make them more affordable and improve liquidity. While this increases the number of shares held by current investors, it does not alter the total value of their holdings.

What is preferred stock?

Preferred shares, or preferred stock, represent a class of ownership in a company that comes with certain advantages over common shares. These include priority in receiving dividends (if the company pays dividends) and a higher claim on the company’s assets during liquidation. 

Preferred stock can take various forms, such as participating preferred shares, cumulative or non-cumulative preferred shares, and compulsory convertible preferred stock (CCPS). 

Among these, CCPS is the most commonly issued type of preferred stock in startups. CCPS grants investors certain privileges while being designed to convert into equity at predefined triggers, such as after a specific time period or during IPO. 

This structure aligns investor interests with the company’s long-term growth.

‍Who is it for?

Investors: Venture capitalists (VCs), private equity firms, and angel investors typically acquire preferred shares in companies. 

Features of preferred stock

1. Priority in dividends

In dividend-paying companies, preferred shareholders are prioritized and receive their dividends before any payments are made to common shareholders.

2. Liquidation preference‍

In the event of liquidation, preferred shareholders are repaid their initial investment (or a multiple of it) before common shareholders receive anything.

3. Conversion rights‍

Preferred shares in startups often include the option to convert into common shares. For instance, a 1:2 conversion ratio means that for every one preferred share, the investor would receive two common shares.

4. Anti-dilution protection

‍In a subsequent funding round, if a company issues new shares at a lower valuation, preferred shareholders with anti-dilution protection may receive additional shares to maintain the value of their original investment.

5. Callable option‍

The company may reserve the right to buy back preferred shares at a specific price after a set date.

‍6. Voting rights‍

In public companies, preferred shareholders typically don’t have voting rights. However, in venture investing, preferred shareholders often negotiate for similar voting rights as common shareholders.

Common stock vs preferred stock

Why do investors seek preferred shares?

Investors seek preferred shares for the added protection they offer compared to common shares.

In different funding rounds, investors often receive preferred shares with varying rights, creating multiple classes of preferred stock. These rights may include liquidation preferences, special voting powers, or other provisions that safeguard their investment and maximize their return in the event of a sale or exit.

For example, in a company, Series A investors might receive shares with a 2x liquidation preference, meaning they get double their investment before common shareholders in the event of a sale. Series B investors might have special voting powers, allowing them to influence key decisions, such as the company's exit strategy.

These special privileges are not granted to common shareholders. Hence, investors prefer preferred shares for greater security and to ensure their interests are protected in critical events.