When you incorporate your startup, you typically issue common stock to yourself and your co-founders. This represents your ownership and sweat equity. However, the moment you decide to raise venture capital, the conversation shifts to a different asset class known as preferred stock.
Preferred stock is a class of ownership that carries specific rights and privileges not afforded to common stockholders. It is the standard instrument used in venture capital financing.
The defining characteristic of preferred stock is seniority. It sits above common stock in the capital structure but below debt. If the company is sold or liquidated, preferred stockholders get their money back before common stockholders see a cent.
The Mechanics of Liquidation Preference
#The primary feature of preferred stock is the liquidation preference. This dictates how the pie is divided during an exit or wind-down.
In a standard scenario, an investor with preferred stock has the right to get their original investment back before any common stockholders are paid. This protects the investor against the downside.
If you sell the company for less than the amount raised, the investors might take everything, leaving the founders with nothing despite owning a large percentage of the company on paper.
There are two main ways this plays out:
- Non-participating Preferred: The investor gets their money back OR they convert to common stock and share in the proceeds according to their ownership percentage. They choose whichever yields more money.
- Participating Preferred: The investor gets their money back AND they then share in the remaining proceeds with common stockholders. This is known as double-dipping.
Comparing Common and Preferred Stock
#It is helpful to view these two stock classes through the lens of risk and reward.
Common Stock
- Held by founders and employees.
- High risk, high potential reward.
- Value is realized only after preferred holders are satisfied.
- Voting rights are standard but often diluted by investor protective provisions.
Preferred Stock
- Held by external investors (Angels, VCs).
- Lower risk due to downside protection.
- Often carries anti-dilution protection to preserve value in down rounds.
- frequently comes with board seats or veto rights over major company decisions.
Founders must understand that ownership percentage does not equal payout percentage. Preferred stock distorts that math.
Why Startups Use This Structure
#You might ask why you cannot just sell common stock to investors. The answer lies in the valuation gap.
Investors are putting in hard cash while the business is still unproven. To bridge the gap between the high risk of failure and the high valuation founders want, investors require structural protections.
Preferred stock aligns the incentives. It allows investors to value the company higher than it is currently worth because they know their capital is protected if things go sideways. It also separates the tax treatment of the shares.
By keeping the price of common stock significantly lower than preferred stock, you can issue options to employees at a low strike price, which is a critical tool for recruiting talent.
As you navigate term sheets, look closely at the terms attached to the preferred stock. Are the preferences standard? Do they include participation? These details define what your equity is actually worth in the end.