Preferred Stock vs. Common Stock: What’s the Difference?
If you’re relatively new to the world of stocks and equity ownership, you may be surprised to learn that there are different types of stocks that confer different benefits and rights to shareholders. The two main types of equity we’ll cover in this guide are preferred stock and common stock. Each type has its own benefits and disadvantages relative to the other, but understanding the basics of preferred stock vs. common stock is essential for creating, interpreting, and managing a strong cap table.
When we talk about equity types, things can get confusing pretty quickly. Perhaps you’ve heard of different stock categories based on investment criteria—growth stocks vs. value stocks, for example, or cyclical stocks vs. non-cyclical stocks. While those distinctions can be important for someone managing a portfolio, the distinction between preferred stock and common stock is much more fundamental.
In other words, preferred shareholders and common shareholders don’t own the same thing. Their ownership rights and privileges may differ in some key ways, which can have a major impact on your decision-making whether you’re an investor or a founder responsible for issuing new shares of equity in your company.
Preferred stock vs. common stock: At-a-glance comparison
- What is preferred stock?
- What is common stock?
- Can a company issue both preferred stock and common stock?
- Can preferred stock be converted into common stock?
- Manage your complex cap table with Pulley
What is preferred stock?
When most people think about stock, preferred stock isn’t the first thing that comes to mind. It’s more likely for common stock to be referred to colloquially as “stock,” because it is—surprise!—much more common. We’ll get into a more comprehensive definition of common stock in a bit; for now, suffice it to say that owning a share of common stock in a company means you own a share of the company itself.
While preferred shares also represent a kind of ownership in a company, they may grant different ownership rights in the company. This often depends on the company and the context. For example, preferred stock issued by a public company usually doesn’t come with the same voting rights as common stock, which means these preferred shareholders generally have less of a say in how a company is run and governed. But this works differently at private companies and specifically at high-growth startups, where VCs who are granted preferred shares often negotiate (successfully) for voting rights.
This is a common theme with preferred stock, which can mean something very different depending on the company in question. Some of the factors that distinguish preferred stock from common stock at public companies don’t necessarily apply to preferred stock at high-growth startups, where VCs can negotiate for preferred stock with more rights and powers.
Let’s keep this in mind as we review some of the highlights of preferred stock.
Preference in the event of asset liquidation
Preferred stockholders are in a preferential position if a company is forced to liquidate, dissolve, or wind up its business operations. This is an especially important benefit for venture capitalists, as startup investing comes with a high degree of risk. VCs typically want to protect their downside in the event of a liquidation, and preferred shares can offer some level of downside protection.
Why? Because preferred shareholders have a higher-priority claim to any assets that must be distributed to shareholders in a liquidity event. With that said, preferred shareholders aren’t on the same level as bondholders or other creditors, who must be paid to ensure the company doesn’t go into default.
Voting and veto rights (though only in certain contexts)
You may have heard that one of the key differences between preferred stock and common stock involves voting rights. This is true in certain contexts, but not in others. For example, preferred shares at public companies typically do not come with voting rights—and this is a major factor that distinguishes them from common shares. But in the context of VC-backed, high-growth startups, preferred shares usually do have voting rights.
Why the distinction? It usually comes down to the power of negotiation.
If you’re a venture capitalist who receives preferred shares for investing in a startup, you’ll probably want to secure some degree of control over that startup’s corporate decision-making. So, you may negotiate for preferred shares that come with voting rights (and in some cases, even more leverage than common shares). At VC-backed startups, it’s not uncommon for preferred shares to have veto rights on certain important corporate decisions. These are the kinds of decisions that can impact the value of preferred shareholders’ investment, such as approving financing rounds and liquidations.
All of this is to say that, yes, preferred shares can come with voting rights. It just depends on the context.
Dividend preference (if there’s a dividend at all)
This is an area where the difference between public companies and high-growth startups is stark. If you’re unfamiliar with the term, a dividend is essentially a share of a company’s profits, typically paid out at regular intervals in cash or (less commonly) additional shares of stock.
If we are talking about how preferred shares work at some public companies, dividend preference plays a big role. In this context, preferred stockholders are typically the first to be paid out in terms of interest or dividends. Preferred shareholders have a higher-priority claim to dividends, so they must receive their regular dividend payment before common shareholders get a piece of the pie.
But—and this is a big but!—this is almost never a benefit preferred shareholders can expect at a high-growth startup. Startups rarely pay dividends, opting to invest any extra money that would go toward a dividend into more growth opportunities. So in this context, dividend preference is rarely one of the main rationales for wanting preferred stock over common stock.
Even at companies that do pay dividends, dividends aren’t guaranteed for all preferred stockholders. There are different classes of preferred stock with different rights vis-a-vis dividend payments. Cumulative preferred stock entitles investors to dividend payments even if a company is struggling and must suspend its dividends for other shareholders; non-cumulative preferred stock doesn’t confer this same right.
On that note, let’s take a look at some of the key features that define common stock.
What is common stock?
As its name implies, common stock is the most common type of stock—and it’s probably the easiest form of equity to wrap your head around. When you buy a company’s stock on a public stock exchange or hear about Elon Musk selling shares of Tesla so he can buy shares of Twitter, you are in the realm of common stock.
Owning a share of common stock means you have an ownership stake in a company, i.e. you own a share of the company itself. This is technically true for preferred stock, too, but common stock may come with certain ownership rights that aren’t on the table with preferred stock. The specific rights a common shareholder is entitled to depends on a number of factors, such as the total number of common shares and the company’s corporate charter.
Here are some of the key features to understand about common stock.
While preferred stock may or may not come with voting rights (see above), common stock is a bit more straightforward in this regard
Common stockholders own a partial stake in a company, which typically entitles them to have a say—sometimes tiny, sometimes quite large—in how that company is governed. The voting rights associated with common stock often allow shareholders to elect a company’s board of directors and vote on other issues that determine how the business is run.
“One share, one vote” is a long-standing principle of how these voting rights are conferred, but it’s not always the case that two shareholders with the same amount of common stock have an equal say. In some cases, companies may adopt a different share structure that confers more voting power to one class of stock vs. another. Google is a famous example of this, with Class A common stock and Class B common stock holding identical rights except that holders of shares of Class A stock are entitled to one vote per share and holders of shares of Class B stock are entitled to 10 votes per share.
Dividend payments—but not in every case
Where dividends exist, common stock has a lower rank than preferred stock when it comes to dividend payouts. This means that preferred shareholders are paid their dividends before common shareholders get theirs.
Even if a company typically pays out dividends at a regular interval, common shareholders may not always receive a dividend payment. It could be the case that a company slashes its dividend payment to common shareholders but continues to pay dividends to preferred shareholders—especially if they own shares of cumulative preferred stock.
What’s true for dividends is also true when it comes to liquidation events—common shareholders do have rights to a company’s assets in the event of an acquisition or IPO, but they have to wait in line behind preferred shareholders. In some cases, common shareholders can even get left with nothing in a liquidation.
Can a company issue both preferred stock and common stock?
Yes, a company can issue both preferred stock and common stock, and both types of equity can be present in a company’s cap table. In fact, cap tables typically specify not only the amount of equity each shareholder owns but the type of equity owned by each shareholder, which may include preferred stock and common stock alongside employee stock options, restricted stock units (RSUs), restricted stock awards (RSAs), and more.
When calculating the total number of fully diluted shares for each shareholder in a cap table, preferred shares are sometimes converted into common shares based on a conversion ratio (for example: one preferred share = three common shares). This makes it easy to compare equity between stakeholders who may hold different equity types.
Can preferred stock be converted into common stock?
Just because equity starts as preferred stock doesn’t mean it has to stay that way forever. Sometimes preferred stock is classified as “convertible,” which means it can be converted to common stock if specific circumstances and/or time benchmarks are met.
This type of convertible preferred stock may be appealing to investors who want exposure to a stock’s potential rise in value but also want to benefit from the passive income associated with preferred stock and its fixed rate of return.
Investors who convert their preferred stock into common stock can more readily benefit from a rise in the common stock’s market price, but there’s no switching back and forth. Once preferred stock is converted, it can’t be converted back and the preferred stockholder becomes a common stockholder in terms of dividends and rights and everything else.
Manage your complex cap table with Pulley
All these different types of equity are enough to make any founder’s head spin. But managing your cap table doesn’t have to be a nightmare—even if its complexity continues to grow. Pulley offers real-time visibility into your company’s equity and fundraiser modeling to help you avoid costly cap-table mistakes.
With Startup, Growth, and Custom plans designed to scale alongside your business, Pulley can quickly adapt to keep pace with your company’s shifting needs. Schedule some time to chat with us today, and we’ll show you tools to help make your equity situation a whole lot clearer.
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