How is preferred stock different from common stock?

Preferred stock, or "preferred shares," offers dividend and asset distribution preference to shareholders. This is especially important for founders & investors to understand because investors can add liquidation preferences to guarantee a certain ROI at the expense of the founder and other shareholders. Take this example: an investor invests $1M for 10% of the company at a $10M valuation with1X liquidation preferences. The startup gets acquired for $5M. Despite the investment halving in value, the investor would still get paid back $1M instead of $500k due to the 1X liquidation preferences, and the remaining $4M would get split among the other shareholders.

Over my years of investing, preferred stock has often been my go-to for newer, riskier ventures. The preferential rights attached to it provide a safety net that common stock just can't match. But, remember, that added layer of protection usually comes at the cost of having limited say in the company's day-to-day matters.

Although the yield curve is currently flat/inverted, causing risk-free assets to compete with high quality preferred stock yields, preferred stock is normally a good way to produce yield. It is an often over-looked asset category, but should be part of a well-balanced, diversified portfolio.

In the event of liquidation, preferred stockholders receive the liquidation preference, before any distribution is made to common stockholders.

Preferred equity is a great way to participate in the upside of a company while limiting your downside with some aspects of structure in the form of preferred dividends. It is a version of mezzanine financing that can be structured creatively such that you accomplish your goals as an investor.

In my portfolio, I reserve common stock for companies where I have a longer-term vision and believe strongly in the team and mission. While it might not have the bells and whistles of preferred stock, it offers a level of control and, potentially, higher upside if the company skyrockets.

Startups should understand that while common stockholders have influence, they have a lower claim on assets and earnings compared to preferred stockholders. Oftentimes times, we see that common stock undergoes vesting periods and a cliff. This is to guarantee that shareholders who provide "sweat equity" stay motivated throughout the first crucial years of a company. It's crucial to strike a balance between control and ownership when structuring equity in early-stage ventures.

Common stock in a private company is generally directly issued to founders and early employees. After reaching a certain amount of employees, private companies often issue common stock option grants, which gives an employee a right to exercise (buy) those shares at a set price. If an employee exercises an option, the company will issue the corresponding number of shares of common stock to the employee. Typically, common stock may perform well in the long run if the value appreciates but it also poses a risk to stockholders because dividend income isn’t guaranteed in the case of most venture-backed corporations. Common stockholders also come last in liquidation preference, receive liquidity only after preferred shareholders are paid.

Start-ups, like the early days of Facebook, routinely issue this stock to founders, staff, and initial investors. Although possessing a subordinate claim to company assets and profits compared to preferred stockholders—as seen when considering a hypothetical bankruptcy of Tesla—common stockholders, similar to those in Microsoft, wield substantial influence in steering the company's trajectory. Business leaders should be mindful that while issuing common stock can attract premier talent, it also dilutes original ownership. Moreover, the voting prowess of common stockholders can sway a company's strategic path, necessitating alignment with the firm's objectives.

In my experience, common stocks are essential in a startup. They’re straightforward, coming without the extra complexities often attached to preferred stocks. Owning common stocks means having a genuine share of the company. They might not come with fancy perks, but they position you solidly if things go well. Having more common stocks also provides the company with more flexibility, allowing it to adapt and pivot as necessary.

Simply put, preferred stock is about protection. In many of the startups I've invested in that failed, my preferred stock ensured I recouped some of my investment during liquidation, long before common stockholders saw a cent. But, on the flip side, in startups that did exceedingly well, my returns were capped because of the very nature of the preferred stock.

Preferred stock can be a strategic choice for startups. It helps maintain control, signals a credible valuation, and attracts investors. Key benefits include reduced ownership dilution, potential for higher ROI, and flexibility in exit strategies. Startups should consider these advantages when structuring their funding rounds.

Tech giant Google's parent company, Alphabet Inc., for instance, has leveraged preferred stock to secure capital without diluting its founders' control. For savvy investors, preferred stock is enticing; it offers an enhanced return on investment and a safety cushion, as seen in the 2008 financial crisis when preferred stockholders of major banks received payouts before common stockholders. Additionally, this stock type provides investors with versatility, enabling them to either exit their position or convert their shares. Business leaders should note that the strategic issuance of preferred stock can foster trust with potential investors, ensuring a balance between capital infusion and maintained control.

I am surprised with the generality of the statements. Preferred stocks are usually governed by law in the jurisdiction where your investment is incorporated. There can be differences in taxation, veto rights, limitation to preferences, limitations in terms of share transfers, regulatory ROFOs etc. When entering into "preferred stock" territory, do not forget that you are entering into a quasi-regulatory territory and you should pay a close eye on the corporate laws of the specific jurisdiction.

The key benefits of preferred shares include: Liquidation preferences. If the company undergoes a liquidation event—be it a selloff, acquisition, or IPO—preferred shareholders have a higher liquidation preference than holders of common stock. This means they will be paid before common shareholders (but after debtholders). Liquidation preferences can be participating or non-participating, which we’ll discuss in detail below. This distinction will affect how preferred shareholders are repaid upon a liquidity event.

While the preferential rights of preferred stock sound great on paper, they can sometimes come with a catch. For instance, I've been in situations where, because of the dividends accumulating on preferred stock, founders were disincentivized from taking the company public or exploring other exit strategies. Preferred stock can occasionally lead to unforeseen tensions between investors and founders.

Preferred stock is a key instrument in venture capital deals, but it comes with caveats. Startups should be aware that it can entail restrictions like dividend obligations, board influence, veto rights, and redemption clauses. These provisions can lead to misalignment of interests among shareholders, especially in challenging scenarios. Additionally, preferred stock may cap upside potential, reduce liquidity, and add complexity to the capital structure. It's crucial for startups to carefully consider these aspects when opting for preferred stock to make informed decisions.

Apple Inc.'s issuance of preferred stock in 2012 offers insight. Apple must ensure consistent dividend payments to preferred shareholders, even when cash flow might be directed elsewhere for growth. This mandate can strain financial flexibility. From an investor's perspective, while they receive dividends, their potential capital appreciation is capped. For instance, if Apple's stock price surged, preferred shareholders wouldn't benefit as much as common shareholders. Also, preferred stocks are often less liquid than common stocks. When large institutional investors tried to offload significant amounts of General Electric's preferred stocks in 2018, they faced challenges finding buyers without offering discounts.

Si las acciones preferentes tienen una preferencia de liquidación agresiva, como por ejemplo, preferencia de 1.5x sobre lo invertido, los fundadores pero también los inversores iniciales podrían encontrarse bajo una liquidation stack tan nociva que no recibiesen nada en la salida.

When company raises money through preferred stock, it may command a high valuation based on the benefits and protection those shares offer, like liquidation preferences. However, this doesn't necessarily mirror the value of the common stock. For instance, while Snap's Series F preferred stock might have been priced at $30.72, the common stock's true value could be different due to the lack of such benefits. When transitioning from a private to a public company, the differential rights of stocks can impact public market pricing. Thus, using valuation methods that adjust for the differences between stock classes, as Uber did when it employed the option pricing method pre-IPO, becomes essential.

Preferred stock often has special rights and preferences, impacting startup valuation. To understand this, startups should recognize that the price per share of preferred stock in a funding round doesn't necessarily reflect common stock's true value. To address this, consider valuation adjustment methods like option pricing, probability-weighted return, or current value. It's crucial for startups to grasp these nuances to make informed decisions in the venture capital landscape.

Preferred stock often comes with rights like conversion, liquidation preference, participation, and drag-along. These terms can significantly impact exit strategies. Startups should carefully consider these terms, as they can affect cash flows, incentives, and bargaining power during exits. It's vital to understand how preferred stock can shape the future of your venture.

As a founder, you should consider establishing a variety of share classes, not limited to one Common, and one Preferred. You are able to assign custom rights and provisions to each of these classes, allowing for greater control over dividend payouts, voting rights, and more.

Preferred stocks are usually governed by law in the jurisdiction where your investment is incorporated. There can be differences in taxation, veto rights, limitation to preferences, limitations in terms of share transfers, regulatory ROFOs etc. When entering into "preferred stock" territory, do not forget that you are entering into a quasi-regulatory territory and you should pay a close eye on the corporate laws of the specific jurisdiction.

-Dividends and Liquidation Priority: Preferred stock often comes with dividend rights and gets paid out first in a liquidation event. This is crucial for investors looking for security and potential upside. -Voting Rights: Common stock usually carries voting rights, crucial for those wanting a say in company decisions. Remember, with preferred stock, voting rights might be limited. -Conversion Features: Preferred stock can often be converted to common stock, offering flexibility for changing investment strategies or capitalizing on company growth.

It is very important to have in mind that common and preferred stocks may have different rights (or may not even be available for issuing) in different jurisdictions outside the United States. Additionally, the exercise of some of those rights may be restricted in such foreign jurisdictions.