What is Common Stock? (And Related Terms)
When raising venture capital, companies can raise equity, debt, or some combination of the two. In this article, we’ll dive deeper into equity-based capital, and in the future will go over debt and hybrid securities.
Common stock is the simplest form of equity issued. Common stock has several characteristics:
- It cannot be converted into another security like a convertible note
- Each share carries one vote
- Dividends can be paid without any limits, but only when declared by a board of directors
- Upon liquidation, common stockholders are last in priority in asset distribution
In the venture ecosystem, common stock is a fairly common form of financing for startups, especially in Series A and onwards in terms of rounds of financing. Common stock is generally held by the founders of a company. Common stock, however, has numerous downsides. Common stock lies at the bottom of the “capital stack.” The capital stack is an overview of who has invested in or lent a company capital. Being at the bottom of the capital stack means common stockholders get paid out last. Additionally, common stock lacks numerous rights, preferences, and protections and does not include a liquidation preference (which we will shortly go over). That’s where preferred stock comes in.
Almost all VC firms and angel investors will require the companies they invest in to issue preferred stock. Preferred stock is a class of stock that provides certain rights, privileges, and preferences for investors.
Preferred stock gets its name from an important feature of the security called liquidation preference. Liquidation preference means that in a sale (or liquidation) of the company, preferred stockholders will give investors their money back before holders of common stock. Liquidation preference essentially dictates how much must be returned to investors before a company’s founders or their employees can receive their share. If the sale of a company is less than the valuation the preferred investors paid, they will get their money back. If the sale is for more than the valuation the preferred investors paid, they will get the percentage of the company they own.
Liquidation preferences often come with a multiple of an investor’s investment as a preference. This is normally “1x” meaning investors will be paid back the full amount of their investment before any other equity holders, but can be 2x or even 3x. Investors may also ask for their preference plus the common interest meaning the investor will be paid their preference and will also share in any additional proceeds in proportion to their equity stake. Founders should be wary of the liquidation preferences they agree to with one investor as that will set what all future investors want because no investor will want other investors in the cap table with a preferred position to themselves. Needless to say, liquidation preferences, especially participating preferred liquidation preferences, are not very founder-friendly.
Non-participating liquidation preferences, or “straight preferences,” are the most commonly used. If an investors’ preferred stock contains these preferences, the investor can choose to either (1) receive their liquidation preference or (2) share in the proceeds in proportion to their equity stake after converting their shares into common stock.
Capped liquidation preferences are sometimes referred to as “partially participating preferred” and are equally favorable to investors and companies. If an investor’s preferred stock contains a capped liquidation preference, the investor will be paid back their preference and then will share in any additional proceeds in proportion to their equity stake. As the name implies, however, an investor’s returns will be capped.
The liquidation preferences that come with preferred stock provide early investors a number of rights and privileges like a right to a board seat, information rights, a right to participate in future rounds to protect their ownership percentage (pro-rata right), a right to purchase any common stock that might come into the market (right of first refusal), a right to participate alongside any common stock that might get sold (co-sale right), and an adjustment in the purchase price to reflect sales of stock at lower prices (anti-dilution rights).
As preferred stock has many variations, of which some can be not founder-friendly, entrepreneurs should seek to educate themselves as to which option is best for them. Investors should also be wary of being too greedy when submitting term sheets as you want to ensure entrepreneurs now and in the future view you as a fair investor. An entrepreneur’s best option may be to have multiple investors at the table to leverage them against each other. Preferred stock can be a win/win for everyone.
The KingsCrowd Advantage
Because preferred stock can sometimes be toxic for founders, equity crowdfunding presents an interesting option for early-stage founders and their companies. The most popular securities in the online private markets are SAFEs and common stock. If you’re an investor who wants the protections granted by preferred stock, then you’ll probably seek that out. KingsCrowd aggregates deal flow across all platforms and will soon allow investors in the space to filter by whichever security through which they want to invest. Our goal at KingsCrowd is to provide the best research, ratings, and analytics for the online private markets. If you’re interested in what we do, please subscribe here.
About: Francis vu
An investment professional with a background in private equity and venture capital having spent time conducting investments at VU Venture Partners and Pacific Oak LLC with a finance and management degree from Tulane University.