There are many different types of equity instruments to choose from and the most commonly issued ones for start-ups are
Common and Preferred stocks.
While both common and preferred stocks represent the equity ownership of a company, they serve different functions and offer different benefits to shareholders.
Before issuing any shares, founders need to understand what the difference between these two equity instruments are!
Common stock is the simplest form of stock and is generally issued to founders and employees. Common stocks are issued during a company’s incorporation and represent the ownership structure, which facilitates decision-making and day-to-day activities.
The amount of common stocks issued to each founder usually differs according to the amount of contribution and how much they bring to the table. Hence, founders that are more involved in running the company will receive greater compensation for their effort by having more common stocks.
Common stocks also come with voting rights, and common stockholders have the right to vote for company decisions such as electing the board of directors.
The value of common stocks comes from the fact that their price can increase significantly over time as the company grows bigger and becomes successful. Common stockholders will be able to sell their stocks at a high price during exit and this creates a huge return on investments for founders and employees.
The downside is that common stocks usually have no liquidation preference. This means that common stockholders will be the last to receive pay-out upon liquidation of the company during exit or winding up.
Common stock is for Friends , Families & Employees.
Preferred stock, as the name suggests, gives shareholders special rights such as preferences to dividends, preference to return of capital upon exit or winding up and more.
Preferred stocks are usually issued to investors during funding because investors demand certain rights including priority during liquidation. Preferred stocks may also be converted into common stocks whereas common stocks do not have this benefit.
Furthermore, if a company misses any dividend payment to the preferred stockholders, it must pay any arrears to preferred stockholders before paying out the common stockholders.
Investors typically will prefer to invest in convertible preference securities which gives them superior rights to common stockholders, priority in terms of payout upon liquidation as well as ability to convert and participate in the upside.
Investors typically will prefer to invest in convertible preference securities
Differences Between Common and Preferred Stocks
Both common stocks and preferred stocks have their pros and cons. Understanding the difference between common stock and preferred stock is essential as they have different purposes and different investors may have different preferences.
It's important for a founder to understand the terms and conditions attached to preference shares and be aware of the obligation.
🙏Thank you for reading!
Qapita, an equity management platform, helps startups to issue and manage both common and preferred stocks.