TLDR
- Though both common and preferred stocks are part of equity and denote a share of ownership, the common share confers voting rights to its holders while preferred stock does not.
- Preferred shareholders have priority over common shareholders in receiving the share of a company's distributable income in the form of dividends and on company assets in the eventuality of bankruptcy and liquidity.
- Preferred stocks share more similarities than differences with bonds; though preferred shareholders, like common shareholders, are part owners of the company, unlike bondholders.
- The two primary sources of returns for both common shareholders and preferred shareholders are dividend payout and capital gains through market price rise but differ in their magnitude—appreciation of preferred share price in the market is minimal.
- The common stock is more volatile in the market and carries high risk, but the potential for appreciation of common stock price is high (theoretically infinite). The preferred stock acts more like a bond with a preset redemption par value.
Source: Unsplash
Startup founders need to take a look at the features, similarities, and peculiarities of each class of equity shares—common stock and preferred stock—before we summarize the differences between them:
What Is Common Stock?
This is the most common class of corporate stock or share. This stock, also called ordinary share outside of the United States, commonly comes to your mind first when anyone refers to stocks or shares in general. For general information, the first common stock ever issued and traded—on Amsterdam Stock Exchange—was by the Dutch East India Company in 1602.
One of the most critical attributes of common stock is that it gives rights to its holder to vote on the company's board of directors and approve major corporate decisions, such as mergers, acquisitions, financial statements, issuing new securities, and payment of dividends. The voting rights that give the holders of the common stock substantial powers vary in proportion to the number of shares the holder owns.
The most attractive distinguishing feature of a common stock is that its market value can rise over time as a company grows more prominent and profitable. This enables investors in common shares to earn enormous returns in the form of capital gains. The flip side is that the price can go down in the market resulting in loss to the shareholders if the company does not perform well.
Another distinguishing factor is that the common shares give you a higher return than most investment vehicles but are volatile and highly risky. However, the historical trend of the market is that in the long run, prices of the common shares of most good companies only rise. The common share is more diluted when an issuing company raises more funding, as each common share is typically identical.
The two factors that are reasons for the big returns a common stock commands are; common shareholders are last in line, after the creditors, bondholders, and preferred stockholders, to get anything from the residual assets in case of liquidation or sell-off and the high level of market volatility the common stock is subjected to.
We also talk about learning how to calculate the price of common stock here.
What Is A Preferred Stock?
Preferred shares, a.k.a preference shares, have some features in common with common shares, but it shares more features with a bond or a debt instrument. The bond issuer who borrows capital from the bondholders makes fixed payments at a fixed interest rate for a specific period as per the terms. The preferred shares also receive a fixed income, not as fixed-rate interest but through a recurring dividend at a preset rate.
The preferred shares represent a share of ownership like common shares, which bondholders do not enjoy. Dividends on preferred stock are often much higher than dividends paid out on the common stock. While the dividend is fixed and almost guaranteed on preferred stock, common stock dividends can change or be skipped. While dividend on common shares is decided and declared by the board of directors at its discretion, dividend on preferred stock is determined in advance and outlined in the prospectus. Preferred stock also has a set redemption price—par value—that a company will eventually pay to redeem it like a bond at maturity of the instrument.
The term sheets for issuances of preferred shares typically come with various protective provisions like liquidation preference that is meant to protect investors if a company exits at a value lower than what was expected at the time of funding. The objective of liquidation preference is to ensure that the investors issued with preferred shares during the financing round receive their money back before the common shareholders, such as founders, employees, and advisors. A liquidation preference is relevant when a company exits via M&A or sells off its assets during bankruptcy. An exit through an IPO typically converts all preferred shareholders into common shareholders automatically.
The two main disadvantages of preferred stock are that they often have no voting rights and limited potential for capital gains through market price rise.
Types of Preferred Shares
Compared to common stock, there are few variants of preferred share. Let us go over some of the popular ones:
- Cumulative Preferred: If the agreed-upon dividend amount is not paid and deferred to a later date, the unpaid dividends accumulate. Any unpaid dividends must be paid to preferred shareholders before paying any dividend to common shareholders.
- Non-cumulative Preferred: The opposite of the cumulative preferred. No unpaid dividends accumulate.
- Convertible Preferred: What is convertible preferred? It is a variant that allows its holder to exchange the preferred shares for common shares at a predetermined fixed price and date. Once the shares have been traded, the benefit of a fixed dividend is given up,, and common shares cannot be converted back to preferred shares.
- Callable: Preferred shares are generally redeemable, vesting the right with the issuer to buy back the stock at a date and fixed price specified in the prospectus. This feature is of more benefit to the issuing company than the shareholder because it essentially enables the company to put a cap on the value of the stock.
- Participating Preferred: The dividend rate of this type of preferred stock increases above the fixed rate if the issuing company makes significant financial gains in any year and meets a predetermined profit target.
- Adjustable-Rate Preferred: Dividend rates change if interest rates change.
- Straight or Fixed-Rate Perpetual: Dividend rates always remain the same, which can be of any type other than the above two.
Learn how to calculate the price of preferred stock.
It is time now to summarize the features of each class of stock—common and preferred—to get a view of the pertinent differences between them to help you make decisions in your startup journey, such as which share class is relevant to which stakeholders and when.
Source: Pexels
Difference Between Preferred and Common Stock: A Summary
One of the main differences between common stock and preferred stock is that common stock gives its shareholders voting rights, while preferred stock does not. Another important differentiator is that preferred stock acts more like a bond with a preset fixed dividend. At the same time, there is no guarantee about the dividend on common shares and common stock. It is also that the redemption price and date are predetermined (though maybe listed on exchanges, its volatility is low). Still, the price of the common share of pre-public companies is determined through valuation, and the market decides that of public companies.
Startup founders who are planning to raise money by issuing stock may offer one of two different kinds. Both classes can be found on major exchanges, but the better choice depends on who you are; fundraising company or investor, institutional or retail investor, and your investment target: short-term income or long-term returns. As names suggest, common stock is the more common, and preferred stock has preference over residual assets in liquidation and for dividends before common stock.
The common practice is that start-up founders allot themselves shares of common stock. They usually earmark a portion of the total shares of common stock to give to employees and advisors or create an option pool. The advisors in this context are those who help startups with strategic advisory and outsourcing of finance, HR, legal, and regulatory functions, in various stages. On the other hand, preferred shares are often issued to angel investors, early-stage venture capital firms, or other institutional investors during seed and series rounds. Venture capitalists and other outside investors who bring funds to a startup typically get preferred stock rather than common stock because they want to protect their existing ownership stake through terms like anti-dilution rights.
It is also essential for you to as startup founders to understand how to calculate common stock and preferred stock and the differences in the method and purpose of these calculations.
The table below lists the key differences between common and preferred stock.
*Upside Potential and *Downside Risk via Investopedia
The Bottom Line
While the common stock is commonly sought by startup founders and short-term high-income-seeking market investors. Preferred stock is preferred by investors who invest in institutional financing rounds like seed and series because it gives them advantages in the future. Most angel investors, VC firms, and other institutional investors will demand preferred stock as a standard norm. Most founders hold common stock for themselves and employees and strategic advisors. Convertible notes (debt) that are convertible into preferred stock in a later round can be one form used by startups in the early rounds.
The institutional startup investors find preferred stock more attractive because it provides increased profitability at lesser risks and a better exit route. It gives them long-term wealth growth and control over their startups until they exit through IPO or conversion to common stock. For retail investors, investing in listed common stock is usually the better choice for long-term growth because of the more significant upside potential.
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