Preferred Stock vs. Common Stock: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
Start-up companies often attract employees and investors by offering them shares of stock in the company usually through preferred stock and common stock.6 min read
Start-up companies often hope to attract employees and investors by offering them shares of stock in the company. There are several different types of stock, but the two most important are preferred stock and common stock. Founders and employees typically receive common stock. Investors usually receive preferred stock.
Companies may receive tax benefits if they issue both common and preferred stock.
What is Common Stock?
As the name suggests, common stock is the most common type of stock. When people think of "stocks," they are usually thinking of common stocks. Owners of common stock --
May be paid dividends, but that is not guaranteed
The company has no obligation to pay common shareholders dividends. Once it does, it can lower or discontinue payments at any time
Usually have the right to influence the direction of the company by voting for members of the company's Board of Directors and on some company policies
Have preemptive rights to buy new shares to maintain the same proportion of ownership if a company issues new shares
Are paid whatever is left, if anything, after creditors, bondholders, and preferred stockholders are paid if the company goes bankrupt.
What is Preferred Stock?
A company usually issues far fewer preferred shares than common shares. Owners of preferred stock --
Are usually guaranteed a fixed income from dividends. If a company misses a guaranteed dividend, it must make it up before paying new dividends and before paying common shareholders
Often don't have voting rights
Are paid before common stockholders if the company goes bankrupt
May have their stock called in at any time, meaning they have to sell it back to the company, usually at a favorable price.
Because preferred shareholders are guaranteed an income, preferred stock is similar in some ways to bonds. Preferred stocks can therefore be thought of as having the characteristics of both stocks and bonds. The features of preferred shares, however, vary, depending on what the company and investors negotiated. Some preferred stocks can be redeemed for either cash or common stock, and some have common-stock-like features such as voting rights and appreciation.
Types of Preferred Stock
Participating preferred stock - Dividend rates increase if common stock dividends are higher.
Adjustable-rate preferred stock - Dividend rates change if interest rates change.
Convertible preferred stock - Can be converted to common stock at a pre-determined price.
Straight or fixed-rate perpetual stock - Dividend rates always remains the same.
Advantages of Common Stock Over Preferred Stock
Common shareholders usually have voting rights that preferred stockholders don't have
Common stock prices may go up more than preferred stock prices. This makes common stocks attractive to investors who expect the company to grow in the future.
Advantages of Preferred Stock Over Common Stock
Companies are usually obligated to pay preferred shareholders dividends on a regular schedule, which makes this type of stock attractive to investors who want a predictable income
Dividend payments to preferred shareholders get paid before dividends get paid to common shareholders
The dividend amount that preferred shareholders receive is usually larger
Preferred shareholders are ahead of common stock shareholders in line for payment when a company goes bankrupt or when another company buys it. For example, say a company collapses and has nothing left except a factory, which it sells for $1 million. At that point, the company will have only $1 million in assets. First, the company is required to use that money to pay off its creditors. Next it pays preferred shareholders out of whatever money is left. If the preferred shareholders hold $1 million worth of stock, then the company will have to pay all its remaining assets to the preferred shareholders, and there will be nothing left to pay the common shareholders, who will walk away empty-handed.
Because preferred stock dividends provide a stable income stream, preferred stock prices are usually less volatile than common stock prices. Preferred stocks tend to trade around their par value (the price when they were issued). Preferred stocks can be traded on the secondary market, on the same exchanges where the company's common stock trades. Like bonds, preferred stocks are rated by credit rating agencies.
Preferred stock may provide tax advantages for institutional investors
Companies and investors can negotiate additional benefits for preferred shareholders
Common Stock for Start-Up Founders and Employees
Start-up founders typically give themselves shares of common stock. They usually leave aside a portion of the total shares of common stock to give to employees. Common shares provide incentives to employees to contribute to the company's success because if the company does well, the value of the shares -- including the shares the employees own -- will go up.
Common shares for employees are often given in the form of stock options. These options are not actual shares themselves. Instead, options give employees the right to purchase shares later at a specific price. If the price of the company's common shares goes up, the employees' purchase price will be lower than the market price. For example, if an employee has an option to purchase stock at $25 per share, and the price of the stock rises in the market to $50, then the employee can purchase his or her shares at half the price of the current market price.
When employees use their options to buy common stock, that is called "exercising" the options. The company may use a vesting schedule. That means the employees will not be able to exercise all their options at once. Instead, a fraction of their options will vest -- that is, become available for purchasing common stock -- each month. The vesting schedule may also include a "cliff." This means that employees have to wait a specified period of time before any of their options start to vest.
For example, a typical vesting schedule for startups would be four years with a 1-year cliff. This usually means that the stock options can start to be exercised only after the first year has passed (the cliff). After one year, one-fourth of the options will vest. From then until the end of the 4-year period, one-forty-eighth of the stock options can be exercised every month as long as the employee holding the options still works for the company.
Preferred Stock for Outside Investors
Venture capitalists and other outside investors who give cash to a start-up typically get preferred stock, rather than common stock.
The company and the investors negotiate the terms of the preferred stocks. The terms are favorable to investors in order to attract outside investors to take on the risks involved in giving money to a start-up. Investors typically seek terms that will help protect their investments.
Some of the terms of preferred stock that investors and companies may negotiate include --
Liquidation preferences, which give investors the right to recover their initial payment at liquidation events, no matter what the fate of the company
Liquidation events include initial public offerings (IPOs), acquisitions, and bankruptcies
Anti-dilution protection, which protects shareholders from losing their share of ownership if investors who come on board after them purchase stock at a lower price
Representation on the Board of Directors
Specific voting rights
Guaranteed and cumulative dividends
Frequently Asked Questions
- How many shares of preferred stocks should a company issue?
The number of preferred shares should be a percentage of the total number of shares. It's generally a small percentage. Preferred shares typically get converted to common shares when a start-up has an IPO or when another company acquires the start-up. So there should be enough common shares available to allow the preferred shareholders to convert their shares.
Beyond that, the specific answer to this question will depend on the particular start-up and the circumstances that it faces. There is no one correct answer to this question. It's a good idea to consult an attorney who has experience working with start-ups.
- How many shares should a start-up issue overall?
The start-up should issue enough shares to provide for:
- Shares for the founders
- A pool of shares for employees
- Future preferred shares
- Future company growth
This is a decision that has to be made at the outset. A start-up corporation needs to include, in its Articles of Incorporation, the maximum number of shares it will issue.
An attorney can help the company with the technical aspects of issuing stocks, as well as help ensure that the company is in compliance with all relevant federal and state securities laws and regulations.
- What happens if a company misses a dividend payment to preferred shareholders?
Even though dividends to preferred shareholders are guaranteed, companies may defer these dividend payments in some circumstances. This gives the company more flexibility than it has with bondholders, whose interest payments must be paid. If the company does miss a dividend payment to preferred shareholders, it has to make up the missed payment before paying dividends to common shareholders.