Preferred stock and common stock (alternatively preferred and common shares) are two classes of equity typically issued by startups as a security representing ownership in a company.
Preferred stock is named so because its owners have a preferential claim whenever a firm pays dividends or distributes assets to its shareholders. However, they give no advantage in corporate governance, and preferred shareholders usually have no voting rights in a company.
What’s important for startup founders to understand is that preferred shares are typically issued for venture investors who negotiate for them in order to receive special rights and privileges unavailable to common shareholders.
- Preferred stock is an equity type representing a corporation's ownership and the right to receive profits from its activities.
- Preferred stock is obtained by investors in in primary sales of equity in equity financing rounds (series A and onwards) or through secondary markets
- In most cases, preferred investors have no or restricted voting rights in corporate governance.
- In case of a liquidity event, preferred shareholders have a bigger claim on the company's assets than regular stockholders but a smaller claim than bondholders.
- Certain investors are attracted to preferred stock because it has qualities of both bonds and common shares.
Preferred stock: Distribution Process
The distribution process of preferred stock is the same as with common stock. Investors can buy shares in cash for a set price during a financing round. Preferred shares may come with unique features, and the terms of the offer specify which apply.
If the company is public, investors may purchase and sell preferred shares on public exchanges. Preferred stock can also be repurchased by the issuing corporation at the current market price if the investor agrees to such a transaction.
Tip: If the stock is callable, the corporation may repurchase the shares without the investor's approval. Some preferred stock agreements feature an expiration date, after which the corporation must buy the investors' shares.
Are you wondering how many shares should you set aside for investors? Learn all a founder needs to know about What percentage of preferred stock to reserve for a financing round.
Preferred Stock in Startups vs Public Companies
The function of preferred shares in private markets (such as venture investment) differs significantly from their position in public markets.
In venture capital, investors usually get preferred shares, while the company's founders and employees get common shares. When it comes to public companies, preferred stock is rather uncommon, as most businesses that go through IPO convert the preferred stock into common shares.
Why is that?
Since dividends are not tax-deductible, most corporations with high credit ratings do not issue preferred shares (unless for regulatory reasons). Therefore, preferred stocks are usually too expensive for strong credits to use as a form of capital.
Preferred and common shares give holders partial ownership of the corporation. But investors get additional benefits from preferred shares. For example, if the company fails, preferred shareholders may receive paid first or be shielded against excessive dilution resulting from subsequent fundraising rounds.
Reasons Why VCs Want Preferred Stock
Venture capitalists and angel investors typically start as minority shareholders in startups they invest in. As such, they have limited control over the direction of the company. Preferred shares help to balance that out and give some extra privileges to investors that help mitigate potential risks associated with their investments.
Here are some of the privileges that stem from owning preferred shares:
- Anti-dilution provisions. Anti-dilution provisions help shield investors from their stock losing value. Dilution happens when the total number of shares in a company increases (e.g. when a new financing round occurs) and investor's share of the company's ownership goes down.
- Liquidation preferences. Liquidation preferences are often used in venture capital contracts to determine who gets paid first in case the company has to be liquidated or in case of the company’s acquisition. Typically holders of preferred stock get paid back first ahead of common shareholders.
- Pro rata rights. With pro rata rights, an investor can take part in one or more future rounds of funding, and maintain their ownership stake in the company.
- Voting rights. Unlike in public companies, preferred stock holders in venture investing can negotiate voting rights that are similar to those of common shareholders, along with the possibility to elect the members of the board of directors.
Preferred Shares Features
Preferred shares have a unique mix of characteristics that distinguish them from debt and common stock. Although the terminology may differ, the following features are usually shared:
- Convertible. Preferred shares are convertible into a certain number of common shares. While some preferred shares specify a conversion date, others need board permission to convert.
- Callable: A call option lets you buy preferred shares at a preset price or par value after a certain date.
- Participating: A feature that allows preferred shareholders to receive a portion of dividends given to common shareholders.
- Cumulative: If a corporation is experiencing financial difficulties and must suspend its dividend, preferred shareholders may have the right to receive payment before the dividend for common shareholders resumes.
- Preference: If the corporation has numerous issues of preferred stock, the highest priority may be first, followed by first preference, second preference, etc.
Note: Bear in mind that these features are mostly related to a post-IPO scenario where a company has moved on from the private sector into being a publicly traded entity. For example, dividends are rather uncommon among startups, as most of the high-growth private companies are focused on scaling their business as quickly as possible. That means reinvesting the profits, instead of distributing the revenue between investors.
Common Stock vs. Preferred Stock
Despite the fact that preferred stock and common stock are both equity products, they have significant differences. First, preferred stock receives a set dividend since preferred shareholders' dividend obligations must be met first. On the other hand, investors of common stock are not necessarily guaranteed to receive a dividend. A firm may pay all dividends (including those from earlier years) to preferred investors before issuing any dividends to regular stockholders.
Second, preferred stock normally does not participate in the same degree in price gain (or depreciation) as ordinary stock. The intrinsic value of preferred stock is the continuous cash distributions received by stockholders. In contrast, it is more difficult to evaluate common stock. However, since common stock is not linked to semi-fixed payments, investors retain it for the possibility of financial appreciation.
Lastly, the terms and circumstances associated with the two categories of equity vary. Typically, preferred investors lack voting rights, although regular stockholders do. Shares of preferred stock may be convertible into common stock, but not vice versa. Callable preferred shares are those that the firm may demand to repurchase at par value. Additionally, preferred stock obtains preferential treatment during liquidations.
Are you interested in the share classes backstory? Or maybe you want to know how many shares you should authorize when issuing stock for your startup? Learn more in our article on How Startup Equity Works.
If investors are interested in producing cash flow from their equity holdings, preferred equity or preferred stock may be a preferable option. This sort of equity investment reflects ownership in a firm and results in dividend payouts receiving priority consideration. Although there are costs associated with this privilege, preferred stock is merely a different kind of corporate ownership.