Whether you’re a first-time founder or a seasoned entrepreneur, understanding the distinctions between common stock and preferred stock is critical to shaping your startup’s equity structure and properly setting up the foundations of the company as it scales. These distinctions also influence how you approach fundraising, how you compensate service providers, and what they mean for various exit scenarios. Let’s break down what these types of stock represent, who typically holds them, and why navigating their complexities can be pivotal to your company’s success.
Common Stock: The Backbone of Startup Ownership
Common stock represents the “foundational equity” of a corporation. One of most important features of common stock is that it grants stockholders ownership rights in the company. Common stock carries voting rights, allowing its holders to have a say in corporate matters, such as electing board members and other key company decisions, as well as fundamental economic rights.
Typically, founders, employees, consultants and advisors are the “sweat equity” contributors in a company (i.e. service providers) – those who earn equity through their time, effort, and contributions. These sweaty equity contributors are granted common stock. This equity structure serves to incentivize early team members, reflect their contributions (through grant sizes, potential future additional “top up” grants and otherwise), and aligns their interests with the long-term success of the business.
However, common stock also carries risks. In the event of liquidation or an exit transaction, common stockholders are last in line to receive proceeds. They are only paid after (a) all debts, expenses, and obligations have been settled (b) and preferred stockholders have been paid out. Being last in the payout hierarchy means that if the exit proceeds, whatever form that might take, are not enough to pay back investors however much money was invested into the company (this amount sometimes known as a “preference stack”) then the common stockholders may get very little or nothing for their shares. However, if a company is successful, common stockholders can benefit significantly from the company’s growth and profitability over time.
Preferred Stock: Additional Privileges for Investors
Unlike common stock, preferred stock is not usually part of a company’s original equity structure at formation. Instead, it is created, authorized and issued during priced round equity financings (i.e. fundraising rounds) – typically when venture capital or other institutional investors purchase equity in the business. At this stage, the terms and conditions of the preferred stock are thoughtfully established, reflecting both the risk investors’ risk tolerance appetite and their expectations for returns.
Preferred stock offers enhanced rights and protections typically intended to lower the risk for investors, which is why preferred stock is almost always reserved for investors. The standard benefits of preferred stock include:
Priority in liquidation or upon sale: Preferred stockholders have priority over common stockholders whenever a company makes cash distributions to stockholders (e.g. dividends) or distributes assets to stockholders in the event the company is sold or liquidated. That means preferred stockholders are always paid before common stockholders in these scenarios (this right is often referred to as a “liquidation preference”). In other cases, this also means that any missed payments to preferred stockholders must be made up before common stockholders receive anything.
Convertible rights: Preferred shares can be converted into common shares at the holder’s discretion (pursuant to certain terms and parameters), benefiting investors if the company appreciates significantly.
Limited antidilution protections: Preferred shares usually come with some sort of antidilution protection. However, contrary to what some believe, this protection is almost always limited to what’s called “broad-based weighted-average antidilution protection” and is only applicable in a down round financing, where a company raises money from investors in a financing round that values the company at a lower price than preferred equity holdings of the investors.
Special voting or veto rights: Preferred stockholders frequently have the right to approve or block significant business decisions (e.g., liquidation, incurring substantial debt, issuing senior equity, licensing material IP, etc.), giving them important influence over company operations. Though it can vary depending on the terms of the fundraising rounds, preferred stockholders will have what is called “protective provisions” in the company’s charter – the rights to approve or block these important company decisions, often requiring the approval of the majority of preferred stockholders.
The Nuances of Founders Preferred Stock
In some instances, founders may seek founders preferred stock. However, note that this term is somewhat of a misnomer, as founders preferred stock typically functions as common stock when held by founders. If transferred to an investor during a priced round, it converts to the series of preferred stock being sold at that time. Only upon conversion does it gain the benefits associated with preferred stock. Issuing founders preferred stock is fairly rare, particularly for first-time founders, as it is generally viewed unfavorably by investors (because it grants to investors what’s sometimes referred to as unpaid liquidation preference – meaning they have preferred shares that contain a liquidation preference without having paid cash to the company to acquire such shares).
Key Takeaways for Founders
Understanding these distinctions between common and preferred stock can help founders better align their goals with the needs of investors, negotiate more effectively during funding rounds, and craft a capital structure that supports long-term growth. Common stock grants fundamental ownership and voting rights but comes with higher potential risk, as common stockholders are last in line for payouts. Preferred stock, on the other hand, provides investors with financial protections such as liquidation priority and important corporate governance measures such as protective provisions, and for these reasons preferred stock grants should be limited to rare occasions, usually tied specifically to financial investments into the company. Founders should carefully consider these differences when structuring equity to balance growth, risk, and investor expectations. For founders navigating these choices, our team at Bowery Legal offers expert guidance to startups at every stage to ensure your capital strategy aligns with sustainable growth and investor expectations.