June 9, 2020

Common vs. Preferred Stock: A brief primer

Common vs. Preferred Stock: A brief primer

What Is Common Stock?

Common stock is a form of corporate ownership shares that serve as a claim on profits (dividends). When a corporation earns a profit or windfall, it is able to re-invest it back into the business. It can also direct a portion of the profit in the form of a dividend to shareholders.

Investors generally receive one vote per owned share to elect board members who have oversight over management decisions. Voting allows them to influence corporate policy and management issues.

What Is Preferred Stock?

With preferred stocks, shareholders typically have no voting rights nor control over management and corporate policy issues. But the company may choose to have a provision which allows for dividend payments based on company profits

In early-stage startups, there are typically two categories of equity holders:

(1) founders and early employees, who are more than likely to receive common shares, and

(2) investors, who are generally issued preferred stock as a receipt for their investment in the company.

Startup founders need to be cognizant of a few key things relative to preferred and common stock. These include but are not limited to:

1. Who has voting rights

2. Clauses that dictate preferred stockholder arrangements such as liquidation preferencesright of first refusalpro-rata rights, and even anti-dilution rights.

Adds Croyle: “These clauses are rules that must be followed, and there are severe ramifications for not doing so, not only from a compliance standpoint but also from a reputation perspective. At the end of the day, you don’t want to be known as a founder who is neglectful with investors.”

3. Allocation of proceeds upon liquidation:

“If a company liquidation event occurs (sale, bankruptcy, etc.), the allocation of proceeds across all shareholders (preferred and common) depends on the ownership structure breakdown and the clauses identified above. These can significantly (and possibly negatively) impact the amount that founders and early employees receive,” says Croyle

Croyle says that keeping track of a real-time Cap Table assessment as well as a Preferred vs. Common breakdown and its impact on future liquidation allocation amounts, is not something most businesses want to deal with, nor is it usually a priority. Rather it would much better for those company founders to focus on their core business.

“You probably have hired outside firms to track all of this and make sure that mistakes are not made. As we all know, however, every touchpoint with these individuals is costly, time-consuming, and also not error-free.”

He concludes:

“Using Equa can provide founders (and investors) a source of truth for their ownership structure. It provides ease with following the rules, it helps to remove the friction in using lawyers and accountants for every single action item, and it allows them to focus on and speed up the lifecycle of their core business.”

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