You cannot build a high-growth startup without understanding the fundamental units of ownership. At the very beginning of company formation, you are dealing with common stock.
Common stock is a security that represents ownership in a corporation. It is the baseline. When you file your articles of incorporation and issue shares to yourself and your co-founders, those are almost exclusively common shares.
This asset class generally comes with voting rights. One share usually equals one vote. This allows common stockholders to elect the board of directors and vote on corporate policies. However, it also sits at the very bottom of the priority stack regarding financial claims.
The Hierarchy of Payouts
#The most critical distinction you must learn is the difference between common stock and preferred stock.
Founders and employees hold common stock. Investors typically hold preferred stock.
This is not a cosmetic difference. It dictates who gets paid first.
Preferred stock comes with rights and privileges that common stock does not have. The most significant is the liquidation preference. This ensures that in the event of a sale, merger, or bankruptcy, preferred stockholders get their money back before common stockholders see a dime.
Think of it as a waterfall. Money flows to the preferred shareholders first. Only after their claims are satisfied does the remaining capital flow down to the common shareholders.
If you sell the company for a modest amount, it is mathematically possible for investors to make money while founders and employees receive nothing. This is a risk you accept when holding common stock.
Why do we keep common stock separate from preferred stock?
It largely comes down to tax implications and employee incentives.
Because common stock has fewer rights and sits lower in the liquidation stack, it is valued lower than preferred stock. This valuation gap is determined by a 409A valuation.
A lower share price for common stock is actually beneficial for your team. It allows you to grant stock options to employees at a lower strike price. If common stock were valued the same as the preferred stock sold to investors, the strike price for employee options would be prohibitively expensive.
This structure allows your team to participate in the upside potential without requiring a massive upfront capital layout.
Questions for the Founder
#Holding common stock requires a long-term view. You are betting that the enterprise value will grow enough to clear the liquidation preferences of your investors and leave significant value for the common shareholders.
As you navigate future funding rounds, you need to consider how new layers of preferred stock affect your position.
- Do you know how much the company needs to sell for in order for your common stock to have value?
- Are you aware of how dilution impacts your voting power versus your financial outcome?
- Does your team understand that their options are derivative of common stock?
Understanding the mechanics of your own equity is not optional. It is the scorekeeping mechanism of the game you are playing.