There are two types of equity: preferred and common. You should understand the differences between the two to fully weigh the pros and cons of each. Note that there are no absolutes in private equity. Issuing stock often involves negotiated terms, and those nuances should be reviewed before making any private equity investment.
Understanding the Difference
At their most basic definition, both common and preferred equity represent an ownership stake in a company. Depending on the legal structure of that company, this equity may be referred to as common and/or preferred stock, shares, units, or interests. For brevity’s sake, we’ll use “stock” within the context of this article. Preferred stock takes precedence over common stock in the capital structure of the company, which means that holders of preferred stock are generally entitled to certain advantages in a variety of situations.
Common stock is the standard unit of ownership that’s created when a company is first formed. The articles of organization will generally state that the company is authorized to issue a set number of common shares, which are typically split between the founders of the company. Some founders may also choose to reserve a percentage of common stock to issue at a later date in conjunction with the exercise of employee stock options or for future equity offerings. Common stockholders are given voting rights, which means they are responsible for electing the company’s board of directors, as well as voting on corporate policy.
Any dividend payments authorized by the company’s board of directors are made to holders of common stock after debt investors are paid interest owed and preferred stockholders have received their full payout. In the event of corporate bankruptcy or liquidation, common stockholders have the least claim over company assets, and will be paid out after creditors, debt investors, and preferred stockholders.
While some amount of ownership and voting dilution should be expected as a company grows, common stock may be susceptible to broad or unfair dilution if the issuer isn’t properly anticipating and managing its equity decisions.
Counteracting Startup Investment Risk Through Diversification
Preferred stock terms tend to include provisions that presumably offer potentially reduced risk, increased profitability, and incentive for a company to achieve a better exit. It’s often considered standard when venture capital and serious angel investors are negotiating an investment. Often, however, preferred stock offers limited – if any – voting rights.
Notable Features of Preferred Stock
As previously mentioned, just about everything is negotiable in private equity fundraising, but preferred stock does take precedence over common stock with respect to dividend and liquidation payments. Other potential features include:
- Convertible to common shares at the option of the holder, either into a fixed amount of common stock or a percentage of common stock outstanding on a future date – while maintaining key preferred rights
- Anti-dilution provisions
- A set dividend payment that can generate return before exit
A Third Type of Stock?
The founders of some “hot” companies have sought to maintain control over corporate decisions by preserving their voting rights as their stock ownership percentage is diluted by multiple rounds of financing.
This relatively new class of equity, called “supervoting stock”, is essentially common stock held by company founders and other select insiders to which the company assigns multiple votes per share. For example, a share of supervoting stock may carry 10 or 20 votes versus the 1 vote represented by a share of common stock. While it can be argued that this allows founders to focus on building their vision, investors and regulators are increasingly pushing back that maintaining supervoting stock in perpetuity is not beneficial.
While supervoting stock will not realistically be offered in a private equity raise, its existence and terms should be part of a reasonable investment due diligence inquiry.
Measuring the Performance of Your Investment
Which is Better?
As the answer is with many things, it depends. Often, the only option for seed and angel investors is preferred stock. Carefully examine the terms and conversion provisions, weigh them in consideration of any supervoting stock, and decide if the company and asset class are a good fit for your investment portfolio.