Preferred vs Common Stock: Impact for Investors, Founders and Employees

Preferred stock and common stock terms often get thrown around in the startup ecosystem, but what do they mean? And how do they impact you—whether you’re a founder, investor, or employee?

These aren’t just finance words for the accountants. They represent important differences in rights, dividends, and risks that can have big implications for everyone involved in a startup.

The types of stock you choose or are offered can shape your financial future and influence the company and growth potential. Below, we’ll walk you through the differences between preferred stock and common stock. You’ll learn how these stock types fit into your startup’s financial model and how they can influence your decisions and success.

What is stock?

Stock represents ownership in a company, and when you issue it, you sell pieces of your business to investors. They become shareholders in your business. This process helps you raise venture capital for growth, product development, or paying off debt.

There are two main types of stock:

1. Preferred stock

2. Common stock

What is preferred stock?

Preferred stock is a type of equity security that gives shareholders certain privileges over common stockholders. These privileges often include fixed dividends and a higher claim on assets in the event of liquidation but usually don’t come with voting rights.

• Dividends: Preferred stockholders typically receive fixed dividends, which are paid out before any dividends are distributed to common stockholders. These dividends can be cumulative preferred stock, meaning if the company skips a dividend payment, it still owes the preferred shareholders the missed payments in the future.

• Liquidation preference: In the event of a company’s liquidation, preferred stockholders have a higher claim on the company’s assets than common stockholders. This means they are paid out before common stockholders if the company is dissolved.

• Convertibility: Many preferred stocks come with the option to convert into a predetermined number of common shares. This can be practical if the value of the common stock increases significantly.

What is common stock?

Common stock is a type of equity security that represents ownership in a company. Common shareholders have voting rights, which allow them to influence corporate decisions. They also have the potential to receive dividends and benefit from capital appreciation.

• Voting Rights: Common stockholders typically have the right to vote on important company matters, such as electing the board of directors and approving major corporate actions. This gives them a voice in the company’s governance.

• Dividend potential: While dividends for common stock aren’t guaranteed, companies may distribute a portion of their profits to common stockholders in the form of dividends. The amount and frequency of these dividends can vary based on the company’s performance and policies.

• Capital appreciation: Common stockholders benefit from the potential increase in the stock’s value over time. If the company grows and becomes more profitable, the value of its common stock can rise, providing capital gains to shareholders.

Preferred stock vs. common stock: key differences

Here’s a side-by-side comparison of the differences between preferred stock vs. common stock:

Voting Rights:

• Preferred Stock: Typically, no voting rights. Preferred shareholders generally don’t have a say in company decisions or the election of the board of directors.

• Common Stock: Usually comes with voting rights. Common stockholders can vote on major corporate issues and elect the board of directors.

Dividends:

• Preferred Stock: Fixed dividends, paid out before common stock dividends. Preferred stock owners receive regular, fixed dividend payments, providing a steady income stream.

• Common Stock: Variable dividends, paid out after preferred stock dividends. Dividends for common stockholders aren’t guaranteed and can fluctuate based on the company’s performance and dividend policy.

Liquidation Preference:

• Preferred Stock: Higher claim in the event of liquidation. If the company is liquidated, preferred stockholders are paid out before common stockholders.

• Common Stock: Lower claim in the event of liquidation. Common stock investors are last in line to receive any remaining assets after debts and preferred stockholders are paid.

Convertibility:

• Preferred Stock: Convertible preferred stock can be converted to common stock under certain conditions. Preferred stockholders may have the option to convert their shares into common stock, usually at a predetermined rate.

• Common Stock: Non-convertible. Common stockholders don’t have the option to convert their shares into preferred stock.

Risk and Return:

• Preferred Stock: Lower risk, lower potential return. Preferred stock offers more stability with fixed dividends and higher liquidation preference but generally provides lower overall returns than common stock.

• Common Stock: Higher risk, higher potential return. Common stockholders face more volatility and risk but have the potential for greater capital appreciation and higher returns if the company performs well.

Implications for investors, founders, and employees

Preferred stocks and common stocks have different advantages and drawbacks for investors, founders, and employees. Here’s what those look like for each individual.

Investors

Risk tolerance

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, while common stock carries higher risk but has the potential for greater returns through capital appreciation.

Income vs. growth

Due to its fixed dividends, preferred stock is ideal for investors seeking steady dividend income. On the other hand, common stock is better suited for those looking for growth potential and willing to accept the volatility that comes with it.

Portfolio diversification

Combining both common and preferred stock can balance a portfolio, providing a mix of income stability and growth potential. This diversification helps mitigate risk and optimize returns.

Exit strategy

Investors should consider the liquidity and marketability of each stock type. Preferred stock might be less liquid but offers predictable returns, while common stock can be more easily traded but comes with greater market volatility.

When Roku had its 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. Roku’s share price started at $15.78 on its first trading day. The lender exercised the warrant, resulting in a net gain of $2.6 million. This shows how preferred stock can significantly benefit investors during a liquidation event.

Founders

Control and decision-making

Issuing preferred shares can help founders retain control over their company since preferred stockholders typically don’t have voting rights. This allows founders to make key decisions without external interference.

Fundraising

Preferred stock can attract investors by offering fixed dividends and liquidation preferences, making it an excellent option without diluting the founders’ control. This can be particularly useful in early-stage fundraising.

Equity distribution

Strategically using preferred and common stock in employee compensation can help align interests and retain talent. Preferred stock might be used for key investors, while common stock options can incentivize employees.

Valuation and exit

The structure of a company’s stock can influence its valuation and attractiveness during exit strategies such as mergers, acquisitions, or IPOs. Preferred stock can improve valuation by attracting high-quality investors, while common stock can be leveraged to motivate employees and drive performance.

Employees

Equity compensation

Common stock options are more common and can offer significant upside if the company grows, while preferred stock options provide more stability with fixed dividends.

Financial security

Preferred stock offers predictable dividends and higher claims in liquidation, providing more financial security compared to common stock.

Career growth

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.

Risks and rewards

Common stock offers higher rewards but greater risk, whereas preferred stock provides more stability but lower potential returns. Employees should consider their financial goals and risk tolerance when evaluating their compensation packages.

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