What is Preferred vs Common stock startup: What SMEs owners need to know?

First-time startup owners need to learn a lot when it comes to analyzing the market, especially in terms of legal issues. The first-time start-up owner must have comprehensive knowledge regarding preferred vs common stock as the difference is huge.

The founders of preferred vs common stock startups work in totally different dimensions therefore it is important to clear it in the very beginning about the premises where the newly launched startup will be situated.

Common stock is an entirely different entity from preferred stock. The first-time startup owners are looking for quick money and excitement while entering the market. They initiate a business in order to earn dollars and huge investments. The first-time founders find preferred stock more exciting than the common stock. They are looking for preferred stock as their newly launched startup is incorporated into the market but they receive common stock at the very beginning.

This might be something new to comprehend for the new startup founders but the experienced business owners suggest that is one of the best learning curves offered by the market. It helps the newly entered owners to understand the dynamics of control and ownership of the business which is very crucial to navigate the business.

Let’s have a detailed look at the preferred vs common stock startup basics so that it can provide a better understanding regarding the differences between the two stocks types.

Common stock

Common stock
source:corporatefinanceinstitue.com

Common stock is basically a unit of different equities in a startup. This unit of equity has all the components for control and economic rights of the start-up.

The founders of the startup receive common stock almost instantly once the new business is incorporated. The consultants and the employees also received the stock and almost at the same time when the stocks are delivered to the owner.

The stocks given to the employees and the consultants will automatically give them a right or purchase a specific number of stocks or shares of the common stock at a given price, anytime in the future.

Common stock can be of more than one kind. There are different classes associated with common stock. If there is more than one class for a common stock then usually the decision is made by exercising voting rights instead of the economic reforms. 

Various economic reforms and rights are associated with preferred stock and are exercised when they are in question.

Preferred stock

Preferred stock
source:kussmaullegal.com

The investors in newly funded start-ups almost always get preferred stock but a little later.

Preferred stock is also known as a unit of different equities of a startup but it has superior economic rights and control as compared to the common stock.

As it is a well-known fact that venture-back start-up businesses comprise different financing rounds. Every round will be given a distinctive series of preferred stock that will be tied up with the finance series.

For instance, if a startup has successfully raised series A along with series B, then it is most likely that series A will be having preferred stock along with the preferred stock of series B.

Characteristics of preferred stock

Investors are readily willing to invest thousands of millions of dollars into potential new startups. The investors who have been in the market are well aware of the potential growth of any new startup and at times give preferential treatment. This preferential treatment is given in the shape of preferred stock.

There are different characteristics of preferred stock that are relevant with the owners of the start-up and also facilitate the investors likewise. The features can accommodate different kinds of investors. Some of the most common ones are discussed below:

Characteristics of preferred stock
source:dividendinvestor.com

Protective provisions:

 Protective provisions are one of the key features of preferred stock. It is given to the preferred stakeholders who have the ability to influence any decisions even vetoing them. Critical decisions such as selling the shares of the company, amendment of any crucial documents, dividends declaration, and many more. 

The common aspect to attract the investors here is to grant them the ability to block any crucial decisions which might have a negative impact on the investments made by the stakeholders of the startup.

Protective provisions grant the investors a supreme blocking power that allows the preferred stakeholders to vote out the decisions made by the common stockholders as well as many other decisions which might not be in the factor of the company.

Protective provisions might seem to be difficult to understand for the new founders of the startup as they might assume that the investors will comply with whatever the founder wants and they will go with the decision of the owners but the reality is another way around. As soon as the investors get to know that a decision is not beneficial for the investors, they block them immediately using their protective provisioned decisions.

The economic model of any given start-up largely depends upon the portfolio of the company. Any kind of exit of a VC can have a massive influence on the company as well as on the owner of the start-up.

Investors can block this kind of exit or acquisition that might be life-changing for a company while pushing the start-up further to grow and achieve a higher level and market position.

Information rights

As the name suggests – information rights are the rights granted to the investors in which they can receive first-hand information regarding the company. The information may revolve around budgets, finances or influencing variables, etc.

This might seem like a harmless activity; the owners of start-ups need to be very careful about granting this crucial information to others. 

The quarterly financial statements of the company are often made public in large conglomerates but for small businesses, this information is shared with only a few investors which might not burden the founder of the startup but agreement of sending this information on request to a certain body might get the founder alert and suspicious.

Board seat

Investors who receive preferred stock also negotiate to get a board seat with the start-up’s founder or board of directors. This allows the preferred stakeholder to elect their favorite or number of board of directors, making their position in the decision-making of the company sounder and stronger.

The investors get a seat on the table and become a lethal part of the strategic innovation and planning of the company.

It is not necessarily a negative thing for startup owners. If the investors have a good intention of making the company proceed further and support the company then this new addition to the board room will be amazing. 

If an investor wants to support the company beyond just sitting back and getting profit, signing checks then the owner of the startup would definitely want to have this kind of investor’s inclusion into the company.

This will also help in the strategic direction of the startup as well as grant insight about how to run the business for an inexperienced, first-time startup owner.

Pro-rata rights

Pro-rata rights grant the investors a special right to maintain their percentage of the ownership in the startup company. For instance, an investor purchases 20% of a company and gets pro-rata rights which means that the investor has the opportunity of purchasing a significant number of shares in order to maintain the 20% ownership valuation of the company. 

One thing to note is that the pro-rata rights do not obligate the investors at any stage to maintain the percentage of their ownership, it simply provides them an option to do so if they want to.

Anti-dilution rights

Anti-dilution rights protect the investors from saving up themselves if the company at any given point decides to dilute. It saves the startup from going haywire or at a down round.

Down round can occur with any company. It means that the company’s total valuation decreases and comes further decreased as compared to a previous round.

In a scenario of a down round, investors do not want to get the company diluted and come forward with anti-dilution protections to their entities. They make sure that more shares of the company are converted into common stock in order to retain the market valuation.

There are many kinds of anti-dilution rights such as “broad-based weighted average” being the most common right.

“Full ratchet” is another anti-dilution right exercised by stakeholders but it is not considered to be friendly for the owner.

Anti-dilution provisions are said to be more complex for startup owners to digest. These provisions compel the founders to work closely with the counsels dealing with them and try their best that this never takes place in reality.

Final verdict

Conclusively, we have discussed common stock vs preferred stock in grave detail along with salient features of preferred stock. There are many other features of preferred stock as well but the ones listed above are the most common and crucial ones. With a better understanding of common stock and preferred stock, the owners of a new startup business can go ahead in their business and prosper.

Recent Posts

Share on facebook
Share on twitter
Share on pinterest