Startups looking to obtain capital through equity financing will often offer two types of stock: common stock and preferred stock. Both can be effective means for raising capital, and each can make for profitable investments for VCs.
If you’re a founder in charge of issuing equity shares in your company – or an investor involved in equity financing – it’s critical to understand the fundamental differences between preferred and common stock. This deep understanding may allow you to feel confident in your decision-making. In addition, it will assist you in developing, evaluating, and managing a robust cap table.
The key difference between preferred and common stock is that preferred stock is similar to a bond with its set value and redemption price, while common stock dividends are often riskier and more volatile. However, there is no limit on how much the price of common stock will reach. Common stock is typically appealing to investors that want to take an active, long-term role in your startup, whereas preferred stockholders tend to be more financially based partners.
Let’s dive a little deeper into the fundamental differences between common stock and preferred stock. Analyzing the differences will help you identify the better choice for your startup and investors.
What is Common Stock?
As its name suggests, common stock is the most common type of stock purchased by investors. It’s a security investment that symbolizes ownership in a firm.
Issuing common stock helps a corporation raise money. For example, many companies issue common stocks to raise money for goals such as corporate expansion, debt repayment, setting up future cash reserves, acquisitions, and so on.
Advantages of common stock
There are several advantages of common stock, including:
- Voting rights: Common stock shareholders are granted voting rights that allow them to take part in electing a board of directors. These shareholders have a say in other major business decisions, including casting votes on policy decisions or mergers and acquisitions.
- High earnings potential: Since returns aren’t guaranteed, there is no cap on how much investors can profit as shareholders. Common stock allows investors to share in a company's long-term profitability. If the company performs well, the common stock may provide substantial returns on investment.
- Liquidity: Common stocks are highly liquid and can be quickly purchased or sold by investors. The flexibility of changing an investment at any time with minimal difficulty can be an important advantage.
- Limited liability: When investors purchase common stock shares, their personal assets are not in danger should the company encounter legal issues. The amount invested determines the degree of your liability.
Disadvantages of common stock
While there are pros to common stock, there are disadvantages that you and your investors should be aware of:
- Limited control: Common stock shareholders are paid last. In addition, investors are subject to the decisions of all other stockholders once adding common stock to their portfolio. As a result, there is some unpredictability and lack of control concerning the profitability of common stocks.
- High-risk investment: The value of common stock fluctuates constantly. Trading that takes place worldwide can affect the outcomes of an investor’s equity value. Therefore, investors should check their portfolios frequently to ensure the performance aligns with their financial objectives.
What is Preferred Stock?
Preferred stock is a type of stock that pays stockholders a set dividend and receives dividend payments ahead of common stock. The price at which a business will finally redeem preferred shares is fixed.
In some aspects, preferred stock is seen as similar to a bond. It makes payouts like bonds — with regular cash distributions and fixed payment terms. Like a bond’s maturity price, the price at which a business will finally redeem preferred shares is fixed. This means that investors are only ready to pay up to this redemption value — no more.
Many companies typically choose to issue preferred stock to secure equity financing without diluting their voting rights.
Advantages of preferred stock
Let’s explore a few of the advantages of preferred stock:
- Security: Preferred stock is typically seen as the “safer, lower-risk” option compared to common stock. Many investors seeking a more secure income and a lesser chance of losses choose to invest in preferred stock.
- First to receive dividends: Each time a business pays a dividend, investors who own the asset will receive it first. A sizable interest in a corporation can generate a large source of income, as some businesses deliver monthly payouts.
- Transparency: When investors buy preferred shares, they are immediately aware of the asset's liquidation value. If the business encounters an irrecoverable issue, investors are instantly informed of the worst-case situation.
- Convertible preferred stock: Convertible preferred stock is the option to convert preferred shares into common stock under certain conditions. Some investors go this route due to the combination of larger dividend income and the potential for the share price to appreciate over time. However, only some businesses offer this option to investors.
Disadvantages of preferred stock
Here are some of the disadvantages of preferred stock you should know:
- Guaranteed dividends may go unpaid: Preferred stock owners receive a cumulative dividend when a business turns a profit. However, if the business's financial status doesn't improve, investors might not receive the dividends they had hoped for.
Common stock vs. preferred stock: which is better?
Both common stock and preferred stock can be profitable investments, and you can find both in major markets. However, there are several distinctions between the two.
Now that you understand the key principles of common and preferred stock, you’ll need to think about what will be more appealing to your future investors and venture capital partners?
- Generally speaking, you should offer common stock if you’re looking to attract investors who are in it for the long haul. Common stock typically gives investors voting rights and entices them to take a long-term view of the company and their equity.
- In most cases, you should offer preferred stock if you’re more focused on obtaining capital, rather than looking for a long-term strategic investment partner.
Simplify Portfolio Management with Fidelity
If you’re brushing up on your knowledge of common vs. preferred stock, your startup might be preparing for a round of equity financing. Fidelity provides an all-in-one platform that helps companies gain a more holistic view of their equity management and cap table strategy – giving your startup an advantage as you approach your next round of funding.
Fidelity’s all-in-one platform helps you handle equity management, corporate governance, fundraising, and documentation. It’s a single platform that makes it easy for you to stay finance-ready at all times.
Find out more about how Fidelity can help your startup automate your equity financing and ace the due diligence process.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.