When evaluating startup opportunities in the private market, it’s easy to focus solely on product innovation or founder charisma. However, a company’s use of financial instruments can influence growth, risk exposure, and exit outcomes. Among the most common are common stock, preferred stock, and convertible notes. Each has its own set of characteristics, benefits, and limitations. In this blog, we’ll break down some key differences, benefits, and tradeoffs between common stock, preferred stock, and convertible notes for private market investors.

Financial Instruments Explained

Common Stock

Common stock represents an ownership stake in a company, which gives the shareholder the opportunity to benefit from the success of the company. This usually occurs through dividends and capital appreciation. With common stock, shareholders are also given voting rights, typically one vote per share, allowing them to participate in important decisions, like electing the board of directors.

Properties of Common Stock

Voting Rights

In general, common stock gives voting rights to its holders. Investors receive a portion of votes based on how many shares they hold, usually one vote per share. When major company decisions need to be made, common stockholders are able to exercise their voting rights on important decisions as mentioned above.

Dividends

Dividends are payments that a company can make to its shareholders when it has the financial capacity to do so. This may be monthly, quarterly, or annually, but is entirely dependent on the availability of funds. When dividends are issued, they are first distributed to preferred shareholders and common shareholders will only receive dividends after preferred shareholders have been fully paid.

However, it is important to note that many private companies choose to not pay dividends and reinvest extra capital into the business.

Potential Benefits and Limitations

Benefits

• Potential for growth through capital appreciation and dividends
• Ownership stake in a company, including voting rights
• Diversification opportunities within a broader investment portfolio

Limitations

• High volatility and illiquidity
• Risk of total loss if the company performs poorly or goes bankrupt
• No guaranteed returns
• Last in line for assets in the event of company liquidation

Preferred Stock

Preferred stock is a type of equity that blends features of both stocks and bonds. As mentioned above, preferred stockholders generally get first priority when it comes to receiving dividends. Preferred shareholders typically do not have voting rights, but they have a higher claim on assets and earnings than common shareholders.

Properties of Preferred Stock

Voting Rights

Some types of preferred stock include voting rights to the shareholder. Generally, common stock provides full voting rights to its holders, preferred stockholders receiving voting rights is uncommon. Even in the case of preferred stockholders receiving voting rights, they may be limited – typically only if the issuer did not pay out dividends.

Redemption Rights

Redemption rights are a provision of preferred stock that give investors the option to have the company buy back their shares after a specified time. These rights are designed to help the investor by providing some liquidity, however; redemption rights are rarely exercised. If redemption rights are exercised, the redemption price is usually equal to the original investment plus any accrued but unpaid dividends.

Conversion Rights

A conversion right can give the issuer or the investor the ability to convert preferred stock into common stock. There are two types of conversion rights: optional and mandatory. With optional conversion, the investor can choose to convert their preferred shares into common shares at a specified time, before the maturity date, or when the stock does not have a maturity date. On the other hand, mandatory conversion requires the investor to convert their preferred shares into common shares after a set period of time, usually five to seven years. This happens automatically and is often called “automatic conversion”.

Potential Benefits and Limitations

Benefits

• Priority over common stock in dividends and liquidation
• Potential fixed or scheduled dividends
• Generally considered less volatile than common stock due to liquidation preference[1]

Limitations

• Illiquidity, private shares are not publicly traded and can be hard to sell
• Valuation uncertainty especially for early-stage companies
• Dependence on company performance for dividend payments

Convertible Notes

Convertible notes are financial instruments that may convert into equity at a pre-determined maturity date or company milestone, typically a financing event outlined within the note’s investment documentation. They are often used by startups during early fundraising rounds because they can defer the valuation question to a later stage.

Properties of Convertible Notes

Principal & Interest

Convertible notes accrue interest on the investor’s loan amount (principal) until conversion or repayment. Interest is usually unpaid until a conversion event, when both principal and accrued interest may convert into equity.

Maturity Date

It is not unlikely that the maturity date, or the loan’s “due date”, will be extended. However, investors can request repayment when the note has matured if no conversion has occurred.

Discount

The discount rate in terms of a convertible note is meant to provide investors with a “reward” for their early investment with the right to convert the loan at a reduced price using a discounted percentage of the original purchase price. Discounts most commonly range from

Valuation Cap

A valuation cap sets a maximum company value for calculating how a convertible note converts into equity. It essentially puts a limit on the price per share the investor will pay if the note converts, which is usually at a lower valuation than the one used in the equity financing round. It can also reward investors for taking on more risk.

When a note has both a discount rate and a valuation cap, the conversion price is typically the lower of the discounted round price or the price resulting from dividing the valuation cap by the fully diluted capitalization of the company immediately prior to the equity financing.

Conversion Provision

The goal of a convertible note investment is to convert to equity at a point in the future. However, this is dependent on successfully attracting and closing subsequent equity financing rounds. This is the most common method of conversion.

Potential Benefits and Limitations

Benefits

• The potential to convert into equity
• Discount or valuation caps can provide early investors with potentially favorable conversion terms
• Quicker and cheaper to execute than priced equity rounds

Limitations

• Uncertain future terms, including dilution and control once the note converts
• No equity rights – like voting – until conversion occurs
• Potential for conversion risk, terms could become unfavorable if no qualified financing occurs

Choosing the Right Investment Opportunities

When deciding between common stock, preferred stock, and convertible notes, private market investors should consider several factors:

Risk Tolerance: Your risk tolerance will significantly influence your choice of investments and selected financial instruments. All investments are risky, and investors should consider the possible impact of total loss of investment when making decisions.

Investment Goals: Determine whether you are seeking capital appreciation, income, or a balance of both. Different financial instruments are used in different ways for different investment goals, and it can be wise to explore the impacts of each before making an investment decision.

Time Horizon: Your investment horizon can also guide your choice. Private market investments have longer time horizons than public market investments and investors should consider the illiquid nature of these types before deciding.

Company Stage and Sector: The stage of the company and the industry sector can also influence your decision. Early-stage companies might offer convertible notes to delay valuation, while more established firms might issue preferred stock.

Influence on Company Decisions: If having a say in the company’s decisions is important to you, common stock might be the best option due to the voting rights it confers.

Final Thoughts

Understanding the nuances between common stock, preferred stock, and convertible notes is important for making informed investment decisions in the private market. Each type of security offers distinct benefits and limitations, and the right choice depends on your individual investment strategy, risk tolerance, and financial goals.

By carefully evaluating these factors and considering the specific characteristics of each security, you can build a diversified portfolio that aligns with your investment objectives.

Want to learn more about financial instruments in the private market? Check out the following blogs to learn more:

• Understanding Equity Deal Terms
• Beyond Stocks and Bonds: Exploring the World of Private Markets
• What Institutional Investors Look for in Private Market Opportunities
• Convertible Notes in the Private Market

Are you looking to invest in startups? Sign up for a MicroVentures account to start investing!

 

[1] https://www.texasfa.com/How-Are-Common-and-Preferred-Stocks-Different.c1019.htm

[2] https://www.forbes.com/sites/kylewestaway/2023/01/10/what-founders-need-to-know-about-convertible-notes-discounts-caps-and-more/?sh=227941e52543

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.