Common Stock vs Preferred Stock Startup: Key Considerations for Founders

As a founder, you're likely no stranger to the complexities of startup finance. One crucial decision you'll need to make is whether to issue common stock or preferred stock to investors.

Common stock represents ownership in your company, giving shareholders voting rights and a claim on assets and profits.

Common stockholders also have a say in major company decisions, making them a key stakeholder in your startup's future.

However, common stockholders' voting power is typically limited to one vote per share, giving them less influence over major decisions.

Preferred stock, on the other hand, offers a higher claim on assets and profits than common stock, but often comes with restrictions on voting power.

Stock options are a type of security that gives the holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price.

In the context of a startup, stock options are often used as a form of compensation for employees, allowing them to purchase company stock at a discounted rate.

Stock options can be exercised at any time after they are granted, but the holder must meet certain conditions, such as the stock reaching a certain price or the employee continuing to work for the company.

The value of a stock option is determined by the difference between the exercise price and the market price of the stock.

For example, if an employee is granted 100 stock options with an exercise price of $10 and the market price of the stock is $20, the value of the stock options would be $1,000.

Stock options can be classified into two main types: call options and put options.

Curious to learn more? Check out: Market Price per Share of Common Stock

If founders are in a good enough position to ask the question about common versus preferred shares, that usually means they can get founder-friendly preferences, and it's worthwhile to go with preferred shares at seed round as they often benefit both investors and the company.

Recommended read: Distinguish between Shares and Stock

Common shares during seed rounds can raise red flags.

The market standard for a liquidation preference is 1x, which means the investor gets paid before anyone else does in the event the business is liquidated.

A non-participating liquidation preference of 1x is a fair deal for investors, and it's only triggered if the total exit value for investors will be lower than the original investment.

Broad-based weighted average anti-dilution gives investors some protection in case of a down round, but it won't completely dilute the founding team.

Investors often acquire at least one board seat in connection with their investment, providing them with a vote and say on the strategic direction of the company.

Pro rata rights give an investor the optional right to maintain their same level of ownership in the company and avoid unwanted dilution of their equity stake.

Protective provisions allow a minority stakeholder to veto or block certain corporate decisions, such as selling the company or taking out too much debt.

Related reading: Investment Banker vs Stock Broker

Issuing preferred shares can help founders retain control over their company since preferred stockholders typically don't have voting rights.

The allocation of proceeds in a liquidation scenario can be significantly impacted by the specific features of the preferred stock issued by a company.

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.

The distinction between common and preferred stock matters because the specific features of preferred stock can significantly impact the allocation of proceeds in a liquidation scenario. This is especially true in cases with participating preferred stock or multiple liquidation preferences, where common shareholders may be left with little or no returns after required payments to preferred shareholders.

In a company sale, all shareholders have access to a portion of the proceeds, but the allocation depends on the percentage of the company held and the specific rights associated with the shares held.

Issuing preferred shares can help founders retain control over their company, as preferred stockholders typically don't have voting rights.

This means founders can make key decisions without external interference, allowing them to steer the company in the direction they see fit.

Preferred stockholders may have a claim on assets in the event of liquidation, but this doesn't necessarily give them a say in how the company is run.

Choosing the right stock can significantly impact a company's valuation and exit strategies. This is evident in the way preferred stock can improve valuation by attracting high-quality investors.

In the case of Roku's IPO in 2017, a venture lender held a warrant for 400,000 shares of Roku's preferred stock with a strike price of $9.17. This structure helped attract investors and ultimately resulted in a net gain of $2.6 million for the lender.

Preferred stock can be a game-changer in exit strategies, as it provides predictable returns and can be more attractive to investors than common stock. This is why companies often use preferred stock to improve their valuation.

On a similar theme: Penny Stock Investors

Common stock, on the other hand, can be leveraged to motivate employees and drive performance. However, it also comes with greater market volatility, which can impact a company's valuation.

The structure of a company's stock can make all the difference in its valuation and exit strategies. By choosing the right stock, companies can attract high-quality investors and increase their chances of success.

Startup funding can be a complex and nuanced topic, especially for startups considering common stock versus preferred stock. In this context, it's essential to understand that venture capitalists often prefer to invest in startups that issue preferred stock, as it provides them with a higher claim on assets and dividends.

Preferred stock typically has a higher claim on assets and dividends than common stock, which can make it more attractive to investors. However, this also means that common stock shareholders may have less control over the company and potentially lower returns on investment.

You exchange preferred stock for funding, giving investors shares in return.

Preferred stock is a type of stock that puts its holder first in line for dividends.

This is achieved by providing investors with financial guarantees, including guaranteed revenues and liquidation preference.

Guaranteed revenues mean preferred stockholders get their profits first when the startup makes money.

Liquidation preference protects stockholders if the startup goes out of business or is sold cheaper than expected, by giving them their money first.

Preferred stock can attract investors with fixed dividends and liquidation preferences, without diluting the founders' control.

Seed round shares are a crucial aspect of startup funding, and for good reason. Offering preferred shares early on is advantageous for both investors and founders, as it sets a beneficial precedent for future rounds.

Early investors are often founder-friendly and genuinely believe in the team and vision, making them more likely to trust the founders and the company's potential.

Consider reading: Types of Preferred Shares

Establishing beneficial preferences early on acts as an "anchor" for preferences in future rounds, setting the stage for more favorable terms later on.

In fact, nearly every time, funds participating in later rounds will copy the preferences set in the initial round, making it wise to get the best possible terms during the seed round when circumstances are most favorable.

Offering common shares initially may raise suspicion among future investors, prompting difficult questions and more scrutiny for the founders.

It's worth noting that offering preferred shares to seed investors is now seen as the norm, making it a non-standard situation to offer only common shares.

You might enjoy: What Are Stock Shares

Setting up a startup involves issuing shares to yourself, co-founders, and employees, which helps establish and share control over the company.

Common stock is the type of share you'll typically issue, giving its holders voting rights and the potential to receive dividends in the future.

The voting right is a key benefit of common shares, allowing shareholders to vote on corporate matters, including structural changes and mergers and acquisitions.

The more shares you own, the greater your voting power is, which is why founders typically reserve up to 10% of shares for key workers while retaining the rest for themselves.

In the early stages, companies usually generate little to no profit, so shareholders may not receive dividends. However, shares can still be used to motivate employees with the promise of future profits.

Founders often receive common stock, but you may come across the term "founder stock", which is not technically accurate.

Equity compensation is a crucial aspect of any startup, and understanding the difference between common stock and preferred stock options is essential.

Common stock options are more common and can offer significant upside if the company grows. This makes them a popular choice for incentivizing employees and aligning their interests with the company's success.

Preferred stock options provide more stability with fixed dividends, which can be attractive for key investors who value predictability.

Holders of non-participating preferred stock receive their initial investment plus any accrued dividends, but that's it.

The key difference between non-participating and participating preferred stock is how the proceeds from a deal are distributed. Participating preferred stock takes a share of the proceeds, in addition to receiving its preference.

In other words, participating preferred stock holders get a taste of the equity apportionment, while non-participating preferred stock holders do not.

Non-participating preferred stock is more straightforward, with holders only receiving their preference and any accrued dividends. Participating preferred stock, on the other hand, requires a more nuanced understanding of the deal's terms and conditions.

Financial security is a top priority for founders and employees alike. Preferred stock offers predictable dividends and higher claims in liquidation, providing more financial security compared to common stock.

Having a predictable income stream can give employees peace of mind and motivation to contribute to the company's success. Employees vested in common stock may be more motivated to contribute to the company’s success, potentially leading to higher stock value and personal financial gain.

Founders who have experienced supportive investors can attest to the importance of simple, founder-friendly preferred share options. Not only will it look more standard, but it will also help the founder put the company in a stronger, more advantageous position when dealing with investors in future rounds.

Additional reading: Stifel Financial Stock

Equity compensation can be a powerful tool for motivating employees and aligning their interests with those of the company.

Common stock options are a popular choice for equity compensation, offering the potential for significant upside if the company grows.

Preferred stock options provide more stability, with fixed dividends that can provide a predictable return on investment.

In general, holders of preferred stock receive preferential returns, meaning they're paid back their initial investment plus a preferential payment before any other proceeds are disbursed.

Preferred stock can be non-participating or participating, with non-participating preferred stock only receiving the preference plus any accrued dividends, while participating preferred stock takes a share of the proceeds along with common stockholders.

For more insights, see: Hedge Fund vs Private Equity vs Venture Capital

As you consider your compensation package, it's essential to understand the key differences between common stock and preferred stock.

In a liquidation scenario, preferred stockholders typically get paid first, with a standard market preference of 1x. This means they'll receive their initial investment back before anyone else.

Protective provisions in preferred stock contracts can also give investors veto power over certain corporate decisions, such as selling the company or taking on too much debt. This can provide a level of stability and security for investors.

However, common stock often offers higher rewards, but with greater risk. It's crucial to consider your financial goals and risk tolerance before making a decision.

When early-stage startups issue equity, employees and founders typically receive common stock. This is the most common type of stock for those involved in the day-to-day operations of the company.

Employees and founders usually receive a large number of shares, often in the form of options.

Investors, on the other hand, generally receive preferred stock, which comes with certain advantages over common stock.

Understanding your risk tolerance is crucial when it comes to investing in stocks. Investors need to consider their risk profiles when choosing between preferred and common stock. Preferred stock offers lower risk with fixed dividends and higher liquidation preference.

Investors with a low risk tolerance may prefer the stability of preferred stock. Common stock, on the other hand, carries higher risk but has the potential for greater returns through capital appreciation. This means that investors who are willing to take on more risk may be rewarded with higher returns.