Types of Shares: Common Stock and Preferred Stock

As a founder, it’s essential to understand the different types of shares – mainly common stock and preferred stock – as they play a crucial role in your company’s equity structure.

Common Stock

Characteristics:

• Ownership and Voting Rights: Common stockholders have ownership in the company and typically have voting rights, which allows them to influence corporate decisions.
• Dividend Payments: Dividends to common shareholders are generally variable and paid out after preferred shareholders receive their dividends.
• Risk and Reward: Common stock is riskier compared to preferred stock, but it also offers higher potential rewards, especially if the company’s value increases significantly.

Advantages for Founders:

• Control: As a founder holding common stock, you maintain voting rights and control over company decisions.
• Potential for High Returns: If the company succeeds, the value of common stock can increase considerably, providing substantial financial benefits.
• Simplicity: Common stock is generally straightforward in terms of rights and valuation, making it easier to manage for early-stage companies.

Preferred Stock

Features:

• Dividend Preference: Preferred stockholders typically receive dividends before common stockholders and often at a fixed rate.
• Liquidation Preference: In the event of a company’s liquidation, preferred stockholders have priority over common stockholders in asset distribution.
• Convertible Feature: Often, preferred stock comes with an option to convert to common stock, offering flexibility to investors.

Investor Preference:

• Reduced Risk: Investors often prefer preferred stock in early-stage companies due to the reduced risk and guaranteed dividends.
• Protection in Downside Scenarios: The liquidation preference protects investors if the company doesn’t perform as expected.

Comparing Common and Preferred Stock

• Risk and Return Profile: Common stock carries a higher risk but also the potential for higher returns, whereas preferred stock offers more stability and protection.
• Voting Rights: Common stock generally comes with voting rights, while preferred stock usually does not, although this can vary.
• Dividend Structure: Preferred stock often has a fixed dividend, while dividends for common stock are variable and dependent on the company’s profitability.
• Priority in Liquidation: In a liquidation event, preferred stockholders have priority over common stockholders in terms of payout.

Conclusion

Understanding the differences between common and preferred stock is crucial for founders. Common stock, typically held by founders, offers control and potential for higher gains but comes with more risk. Preferred stock, often favored by investors, offers stability and certain protections. Balancing these two types of stock is key to structuring your company’s equity in a way that aligns with your goals and attracts the right investors.