In this blog post, we provide an overview of “preferred stock” and “common stock” for an investor who is considering investment opportunities in startups. Note that this is a very broad topic requiring careful consideration, so the information below is not exhaustive – as always when it comes to investing in startups, doing your own due diligence is a critical part of the process.
It is helpful to understand the terms ‘common stock’ and ‘preferred stock’ in the context of public markets first. With that baseline understanding, we can move on to the discussion in the context of private markets.
What is Common Stock?
Common stock is offered by publicly listed companies and, as the name suggests, is the type of stock most commonly purchased by investors – it is what most people would typically think of when it comes to stocks. A common stock is a security that represents ownership in the company. Holders of common stock have the right to elect a board of directors that makes decisions for the company. Some decisions require stockholder votes. The value of your stock can change throughout the trading day and the value can go up as well as down. It is possible to lose your entire investment.
What is Preferred Stock?
Preferred stock is a special class of stock and comes with certain rights. The term “preferred” comes from the preferential treatment received by holders of preferred stock, primarily being the following:
- Preferred stocks may receive a higher dividend yield than common stocks;
- Holders of preferred stock in a company are paid dividends before holders of common stock in the company;
- If a company is liquidated, payments will be prioritized to holders of preferred stock over owners of common stock.
Preferred stock also has risks similar to common stock.
Preferred Stock and Common Stock in Private Markets
When investing in startups, common stock is usually not offered to investors. Investors tend to invest in preferred stock or convertible instruments such as Convertible Notes, SAFEs etc. These convertible instruments typically convert to preferred stock at certain trigger events, such as a ‘qualified financing’. To complicate matters further, preferred stockholders usually have the option to convert to common stock at certain other trigger events for example, when the startup is acquired, or if the startup has an initial public offering (“IPO”) The following sections discuss the similarities and differences between common stock and preferred stock in more detail.
1. Company Ownership
Common stock and preferred stock each represent ownership in the company, so there is no major difference between them in this area.
2. Voting Rights
Startup common stock and preferred stock generally have voting rights. In some matters, each class votes separately, while in some matters, all classes vote together as converted. Voting rights, however, are not the most important differentiator between common and preferred stock.
3. Seniority / Priority
Seniority or priority refers to an investor’s place in the payment queue. When it comes to investments, you want to be as close to the front of the line as possible, because this increases your chances of protecting your capital if the company is not successful. Preferred stockholders have a claim on a company’s payout at the time of a liquidity event ahead of common stockholders – this means they are ‘senior’ to common stockholders.
4. Liquidation Preferences
Liquidation Preference is a term that determines how much preferred stockholders are paid out before common stockholders. This is typically set as a multiple of the investment. In the U.S., liquidation preference is generally set at 1x. This means that preferred stockholders will get paid out one times their investment before any money goes to common stockholders. Liquidation Preference can also be 1.5x, 2x or more. This is particularly relevant in the case of a bankruptcy or in cases when the exit is not very big. In a liquidation scenario, preferred stockholders are paid before common stockholders.
5. Pro-Rata Investment Opportunity
Companies raise capital by seeking investment in various funding rounds including Pre-Seed Funding, Seed Funding, and Series A, B, and C rounds. More stock is issued at each funding round, so if you do not participate in those rounds, your share of ownership in the company goes down. A pro-rata right gives you the opportunity to invest in subsequent funding rounds so you can maintain your ownership percentage. Preferred stockholders can get pro-rata investment rights as part of their purchase of preferred stock if the conditions allow.
6. Anti-Dilution Rights
As discussed above under pro-rata investment rights, if you invest in an early round at a high valuation, but the startup accepts financing at a lower valuation later, your ownership stake may become diluted. As a preferred stockholder, you may receive anti-dilution rights that allow you to avoid dilution of your stock holding. This would entitle you to additional shares from the startup in the event of a ‘down-round’.
7. Information Rights
“Knowledge is Power” is a famous saying with good reason. Having detailed information about a company’s financial position and the status of their operation is vital for investors. Major holders of preferred stock may be entitled to information rights as part of their stock purchase. ‘Major holders’ are typically defined in any Preferred Agreement and the definition may vary from one agreement to another. However, we should understand Major holders as investors that invest large amounts of capital into the startup – usually upwards of half a million dollars.
8. Participating Preferred Stock
Usually, when the time comes for a liquidity event, preferred stockholders may choose to receive their liquidation preference or, they may choose to convert to common. A special clause within a Preferred Stock agreement – the Participation clause – enables them to do both. This typically enables Preferred stockholders to first receive their Liquidation preference, and then, in addition, participate in the deal as a common shareholder. This is commonly termed ‘double-dipping’.
9. Conversion Rights
Conversion rights are an important consideration when purchasing preferred stock, so make sure to review the offer documents prior to investing as each offering may be different. Most preferred stocks include conversion rights. This means that preferred stock can be converted to common stock at an agreed date and an agreed conversion ratio. Knowing the terms of the conversion in advance allows an investor to plan ahead.
Pros and Cons of Common Stock and Preferred Stock
Now that we have discussed the various elements of preferred stock and common stock, let us summarize the pros and cons. Some key advantages of preferred stock over common stock include:
- Preferred stockholders have higher payment priority (Seniority) than common stockholders in the event of a liquidation;
- A higher liquidation preference enables them to get some multiple of their money back before any payouts are made to common stockholders;
- Additional potential benefits such as pro-rata investment, anti-dilution provisions, and information rights may apply to preferred stock
In summary, preferred stock usually has greater protections than common stock.
A great way for investors to build their knowledge around investing in startups and the utilization of preferred stock is to review example financing agreements that can be used in company funding rounds and capital raises, such as the standard documents provided by Series Seed. To increase your knowledge around investing in startups, check out angel investing blogs like Propel(x) for more information and resources.
Again, please note that this list is not exhaustive, and it is critical for investors to do their own due diligence before making any investment decisions. Investors should keep in mind that all investments carry risk and there is no guarantee that they will be profitable. Investors should carefully review the terms of any investment opportunity prior to investing.