Preferred stock and common stock represent different types of equity ownership in a company, each with distinct rights, benefits, and risks. Understanding these differences is crucial for investors, employees, and entrepreneurs as they navigate equity investments and company ownership structures.
Overview of Stock Types
Common Stock
Common stock represents basic ownership in a corporation and typically comes with voting rights and a residual claim on company assets. Most public companies issue common stock, and it's the type of equity most people think of when they hear "stock ownership."
Preferred Stock
Preferred stock is a hybrid security that combines features of both stocks and bonds. It typically provides preferential treatment in dividends and liquidation but may have limited or no voting rights. Preferred stock is common in private company investments and venture capital.
Key Differences Summary
| Feature | Common Stock | Preferred Stock |
|---|
| Voting Rights | Yes (typically 1 vote per share) | Limited or none |
| Dividend Priority | After preferred dividends | Before common dividends |
| Liquidation Priority | After all debt and preferred | Before common stock |
| Upside Potential | Unlimited | Often capped |
| Risk Level | Higher | Lower |
Common Stock in Detail
Rights and Benefits
- Voting Rights: Elect board of directors and vote on major corporate decisions
- Residual Claims: Right to remaining assets after debt and preferred stock
- Unlimited Upside: No cap on potential returns if company succeeds
- Dividend Rights: Receive dividends when declared by the board
- Preemptive Rights: May have right to maintain ownership percentage
Typical Holders
- Founders: Usually receive common stock at incorporation
- Employees: Stock options typically convert to common stock
- Public Investors: Most public market investors own common stock
- Early Investors: Some angel investors receive common stock
Risks
Common Stock Risks
- Last in line for liquidation proceeds
- No dividend guarantees
- Higher volatility
- Can lose entire investment
- Dilution from new issuances
Preferred Stock in Detail
Types of Preferred Stock
- Cumulative Preferred: Unpaid dividends accumulate and must be paid later
- Non-Cumulative Preferred: Unpaid dividends are forfeited
- Participating Preferred: Receives liquidation preference AND upside participation
- Non-Participating Preferred: Receives liquidation preference OR conversion value
- Convertible Preferred: Can convert to common stock
Liquidation Preferences
Liquidation preferences determine how proceeds are distributed in a sale or liquidation:
- 1x Non-Participating: Get money back OR convert to common (choose better option)
- 1x Participating: Get money back AND participate in remaining proceeds
- Multiple Preferences: 2x, 3x, etc. of original investment before others
- Capped Participation: Participation limited to certain multiple
Anti-Dilution Protection
Dilution Protection Methods
- • Full Ratchet: Adjust to lowest price of any new issuance
- • Weighted Average: Adjustment based on amount and price of new shares
- • Broad-Based: Includes more shares in calculation (founder-friendly)
- • Narrow-Based: Includes fewer shares in calculation (investor-friendly)
Dividend Rights and Payments
Preferred Stock Dividends
- Fixed Rate: Often specified as percentage of liquidation preference
- Priority Payment: Must be paid before common stock dividends
- Cumulative vs. Non-Cumulative: Whether unpaid dividends accumulate
- PIK Dividends: Payment-in-kind dividends paid with additional shares
Common Stock Dividends
- Discretionary: Board decides whether and when to pay
- Variable Amount: No guaranteed dividend rate
- Growth Potential: May increase as company grows
- Tax Treatment: May qualify for favorable tax rates
Dividend Example
Dividend Distribution Example
Company declares $1M in dividends:
- Preferred Stock: 8% dividend rate on $5M investment = $400K first
- Remaining $600K available for common stock dividends
- Common stockholders receive pro-rata share of remaining $600K
Conversion Rights
Preferred to Common Conversion
Most preferred stock in private companies includes conversion rights allowing conversion to common stock:
- Voluntary Conversion: Holder chooses when to convert
- Automatic Conversion: Triggers upon certain events (IPO, qualified financing)
- Conversion Ratio: Number of common shares received per preferred share
- Conversion Price: Effective price per common share upon conversion
Conversion Scenarios
- IPO Conversion: Automatic conversion upon public offering
- Sale Optimization: Convert if common stock receives better treatment
- Majority Vote: Conversion upon vote by preferred stockholders
- Time-Based: Conversion after specified time period
Voting Rights and Control
Common Stock Voting
- Board Elections: Vote for board of directors
- Major Decisions: Mergers, acquisitions, major corporate changes
- Shareholder Proposals: Vote on shareholder-initiated proposals
- Proxy Voting: Can delegate voting rights to others
Preferred Stock Voting
- Limited Voting: Usually no voting rights on routine matters
- Protective Provisions: Veto rights on specific actions
- Class Voting: Separate votes as a class on certain matters
- Board Representation: Right to elect specific board members
Control Considerations
Control Mechanisms
- Voting control through common stock ownership
- Protective provisions limiting management actions
- Board control through preferred stock rights
- Liquidation preferences affecting exit decisions
Valuation and Economic Differences
Valuation Factors
- Common Stock: Valued based on residual value after preferred rights
- Preferred Stock: Valued based on liquidation preference plus conversion option
- Option Value: Conversion feature provides option-like upside
- Risk Premium: Preferred stock typically trades at premium to common
Exit Scenario Analysis
$50M Exit Example
Assumptions: $10M Series A investment, 1x non-participating preferred
- Preferred Stock: Receives $10M liquidation preference
- Common Stock: Shares remaining $40M pro-rata
- If conversion better: Preferred converts and shares $50M pro-rata
Risk-Return Profiles
- Preferred Stock: Lower risk, moderate return potential, downside protection
- Common Stock: Higher risk, unlimited upside, greater downside exposure
- Risk-Adjusted Returns: Preferred stock often provides better risk-adjusted returns
Tax Implications
Income Tax Treatment
- Dividends: Both types may qualify for preferential dividend tax rates
- Capital Gains: Sale proceeds taxed as capital gains
- Conversion: Generally not taxable event
- Section 1202: Both may qualify for QSBS tax benefits
Special Considerations
- Constructive Dividends: Certain preferred rights may create taxable income
- Section 409A: Valuation requirements for option pricing
- ISO Treatment: Employee stock options typically convert to common
Strategic Considerations
For Investors
- Risk Tolerance: Preferred stock for lower risk, common for higher upside
- Investment Stage: Earlier stages may favor preferred stock protections
- Control Preferences: Common stock for voting control
- Liquidity Needs: Consider conversion and exit scenarios
For Companies
- Cost of Capital: Preferred stock may have higher effective cost
- Control Retention: Common stock issuance preserves founder control
- Future Flexibility: Complex preferred structures may limit future options
- Employee Incentives: Common stock options align employee interests
For Employees
Employee Considerations
- Stock options typically convert to common stock
- Understand liquidation preferences impact on returns
- Consider exercise timing for tax optimization
- Evaluate company's capital structure and investor rights
Conclusion
Understanding the differences between preferred and common stock is essential for anyone involved in equity investments or company ownership. While common stock offers unlimited upside potential and voting control, preferred stock provides downside protection and priority in distributions.
The choice between preferred and common stock depends on individual risk tolerance, investment objectives, and role in the company. Investors typically prefer the protection of preferred stock, while founders and employees often hold common stock for its upside potential and control rights.
Both types of stock play important roles in company capital structures, and understanding their characteristics helps stakeholders make informed decisions about investments, equity compensation, and corporate governance. As companies evolve and markets change, the relative benefits of each type of stock may shift, making ongoing education and analysis crucial for success.