Investing in private markets offers a multitude of opportunities for investors, but it also demands a solid understanding of the different types of securities available. 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 talk about some key differences, benefits and limitations, and things to consider when choosing to add to your investment portfolio.

Common Stock

Key Differences and Characteristics

Common stock represents ownership in a company and entitles the shareholder to a portion of the company’s profits, usually through dividends and capital appreciation. Shareholders also have voting rights, typically one vote per share, which may allow them to influence corporate decisions and the election of the board of directors.

Benefits

Capital Appreciation: Common stockholders can benefit from the company’s growth and success. If the company performs well, the stock price could increase, which has the potential for investors to see a return.

Voting Rights: Having a say in major company decisions can be an advantage for investors who want to influence the company’s direction.

Dividends: Common stockholders have the potential of receiving dividends from the issuer of the stock when or if capital allows. The frequency of dividends may be monthly, quarterly, or annually. However, if there are preferred stockholders, they are paid out in advance of common stockholders.

Limitations

Risk: Common stockholders are the last to receive assets in the event of liquidation or dividend allotments, after debt holders and preferred shareholders.

Dividend Uncertainty: Dividends are not guaranteed and can fluctuate based on the company’s profitability.

Illiquidity: No matter the financial instrument, investments in privately held companies are illiquid and likely are not able to be bought and sold as quickly as public market investments.

Preferred Stock

Key Differences and Characteristics

Preferred stock generally provides a priority claim to dividends and are paid out before common stock dividends. Preferred shareholders typically do not have voting rights, but they have a higher claim on assets and earnings than common shareholders.

Benefits

Fixed Dividends: Preferred stockholders typically receive dividends at a predetermined rate, which can provide a steady income stream.

Priority in Dividends and Liquidation: In case of liquidation, preferred stockholders are paid before common stockholders. They also receive dividends before common stockholders.

Limitations

Limited Upside Potential: The fixed dividend nature of preferred stock can limit investors as they may not have the potential to benefit from company growth and increased profitability like common stockholders’ dividends.

Dividend Risk: While preferred shareholders may receive dividends, they are not guaranteed and can be deferred or omitted if the company faces financial difficulties.

Lack of Voting Rights: Preferred shareholders usually do not have voting rights, meaning they cannot influence company decisions or vote on board members.

Convertible Notes

Key Differences and Characteristics

Convertible notes are a form of short-term debt that converts 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.

Benefits

Flexibility: Convertible notes can provide flexibility to both investors and companies by delaying the valuation until the company is more established.

Potential for Upside: Investors may benefit from the appreciation of the company’s equity once the note converts to stock.

Limitations

Uncertainty in Terms: The exact terms of conversion can be uncertain and depend on future financing rounds.

Dilution Risk: As with any equity conversion, there is a risk of dilution, particularly if the conversion terms are not advantageous.

Complexity: The terms and conditions of convertible notes can be complex, requiring careful scrutiny and understanding.

Choosing the Right Investment for Your Portfolio

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 in investments and selected financial instrument. 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 making a decision.

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? Check out the following MicroVentures blogs to learn more:

• Common Stock in the Private Market
• Preferred Stock in the Private Market
• Convertible Notes in the Private Market
• Crowd Note vs. Convertible Note: What’s the Difference?

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

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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.