Preferred Stock vs Common Stock: What Startup Founders Should Know

While both common and preferred shares provide an ownership stake in a company, there are significant differences between them. It is important to consider these differences when deciding what type of equity structure to implement in a startup. 

Founders should carefully evaluate their options and work with legal counsel to understand how each type of share will impact their long-term goals before making any decisions about issuing equity. If you’re looking for legal counsel to help you navigate this question, you can contact us here.

Startup Common Stock

Common stock is the most basic form of equity ownership in a startup. Most founders and employees have common stock in their company. Common stockholders are the owners of the company, and they have the right to vote on certain matters. They also have the potential to share in the profits of the business, as they will receive dividends if and when the company pays them out. However, common stockholders typically have the lowest priority when it comes to receiving dividends or other distributions. In addition, common stockholders are usually last in line when it comes to receiving assets in a liquidation event.

Startup Preferred Stock

Preferred stock is a type of equity security that offers certain benefits or preferences over common stock. For example, preferred stockholders may be entitled to receive dividends before common stockholders, have the right to vote on certain matters and the ability to appoint board members. They may also be the first to receive a payout upon acquisition. Because of these added benefits, preferred shares are generally more valuable than common shares.

In startups, preferred shares are typically held by investors.

If you’re interested in the standard preferences for investors, check out our Founder’s Guide to Series A or Founder’s Guide to Series Funding.

The Potential Impact of Preferences Attached to Preferred Shares on Common Shareholders

Preferred stockholders generally receive priority when receiving dividends or payouts during liquidation or acquisition. However, not all preferred shares are equal. Some may have more favorable terms and conditions, such as higher dividends or more voting power, which can impact the value of common shares. For example, preferred shares with a liquidation preference of 2x means that preferred shareholders receive twice their initial investment before common shareholders receive any payout. Preferred shares with greater voting rights can limit the power of common shareholders. Therefore, founders and potential investors should carefully consider the terms and conditions of any preferred shares offered before investing in a startup.

How the Terms of Preferred Stock Can Impact a Startup’s Ability to Raise Future Funding

The terms and conditions of preferred shares can impact a startup’s ability to raise future funding. If a startup issues preferred shares with highly favorable terms such as a high dividend rate or liquidation preference, it may be less attractive for potential investors to invest in the company later on. This is because these preferences can significantly reduce the potential returns for common shareholders and make it harder for new investors to negotiate favorable/superior terms. Furthermore, if preferred shares have more voting rights than common shares, existing investors may have more control over company decisions. This can limit the power and influence of new investors.

It is important for founders to work with their legal team to negotiate appropriate preferences based on the stage of growth. If you need legal counsel, click here to contact us.

The Role of Preferred Stock in Attracting Investors

One of the main advantages of offering preferred stock in a startup is that it can attract investors effectively. Investors undertake a huge amount of risk when they invest in a startup. The preferences serve as an inducement for investors, providing them with a certain amount of protection and priority over common stockholders. Since preferred stock usually carries a higher price tag than common stock, startups could potentially raise more funds by offering preferred shares to investors.

However, startups should carefully consider the terms and conditions of their preferred stock offerings before moving forward. Investors will want to know the exact rights they have as preferred shareholders, and they may also want to see a clear path to realizing a return on their investment. Startups should work closely with legal and financial experts to ensure that their preferred stock offerings are structured in a way that is attractive and fair to both the company and its investors.

If you are interested in the standard preferences for investors, please check out our Founder’s Guide to Series A or Founder’s Guide to Seed Funding.

10 Rookie Startup Legal Mistakes

Download this FREE guide today to learn how to avoid these common legal mistakes. These basic tips will save your startup time and money.
Download Free Guide
  • This field is for validation purposes and should be left unchanged.