All corporations, whether public or private, have shares of stock. Each share carries a price, whether established by the market (investors) or approximated by the company itself (pre-money valuation), that when combined, represent 100% of the company’s equity.
When one buys a share of stock, they are buying a sliver of equity ownership in the company. The type of stock they purchase will dictate if and when they have rights to distributions of money and votes on corporate actions.
In this article, we cover what each form of ownership is (common stock vs. preferred stock) and how they differ for private and public companies.
What is Common Stock?
Common stock is what corporations most frequently issue to owners (founders), employees (option pool), and retail investors. Common stock forms the bottom of the liquidation preference pyramid which means any payout after an acquisition or liquidation will only trickle down if the financial rights of the upper-pyramid’s senior shareholders and debt holders are satisfied.
Shares of common stock usually carry voting rights for big corporate decisions proportional to the number of shares; a 1:1 ratio of shares to votes. Common stock can be further segmented into various classes that carry differing voting rights, but more on that shortly.
What is Preferred Stock?
Preferred stock in public companies can be compared closely to bonds because it guarantees a dividend and does not have the same long-term potential for appreciation as common stock does. Preferred stock in private companies is most often issued to angel investors, venture capitalists, or other large institutional investors.
Preferred stock owners are the second tier on the liquidation preference pyramid because they will receive preference over common stockholders when distributions are made such as dividends, acquisition, or bankruptcy.
In private companies, preferred stock often comes with additional voting rights and protective provisions that limit downside risk, but in publicly traded companies, preferred stock carries no voting rights.
Instead, preferred shares of public companies are usually guaranteed a dividend. If the company issues a dividend, the preferred stockholders are entitled to this payment, although it can be distributed at a later date, unlike common stockholders who, if a dividend is withheld, will not be paid in arrears.
Preferred stock can be cumulative, meaning that if the company is forced to defer dividend payments to a later date, any unpaid dividends will accumulate and must be paid to the shareholder.
Non-cumulative preferred stock is the opposite, where deferred dividends will not accumulate and only when the company begins issuing dividends again will the normal dividend payments continue.
Preferred stock in private companies is essentially the inverse of those in public companies:
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Angel investors and venture capitalists typically invest with the stipulation that their shares will be preferred, which has some advantages over privately-held common stock. Depending on the terms of the deal, the investor will get to set their preferences for handling dilution and decision-making power. When a company goes public, most of the time the preferred stock of angel and venture investors will convert into common stock.
Common Stock vs. Preferred
Common and preferred stock are both shares of equity in the company, but that’s about where the similarities end. When considering who gets a return first in the event of a liquidation or acquisition, preferred shareholders take priority over common, although debt is still senior to preferred.
We’ve also already mentioned that preferred shareholders are typically guaranteed a dividend should the company issue one and, unlike holders of common stock, they will receive each and every payment even if it is deferred to a later date.
This means that risk, in the sense of losing the entirety of one’s investment, is lower for owners of preferred stock. Although, in lieu of this reduced risk, preferred stockholders do not receive the right to vote on the company’s future, while common shareholders do.
Preferred stock is usually priced based on the dividend payment, like how a bond can be priced by discounting future cash flows from interest rates. This caps the growth potential of the preferred stock while common stock has theoretically unlimited growth potential.
Classes of Shares and Super-Voting
In some situations, a company will issue a different class of their common stock to assign different voting rights and attract more retail investors, among other reasons. Commonly delineated as classes A, B, and C. Depending on the company and structure of the classes, each class can carry different prices, privileges, and voting rights.
The exact ratio of votes per share can be decided by the company, but can carry either zero votes, one vote as in standard common stock, or a multiple of votes (i.e. 10x). For example, Google has three classes of stock with different voting rights:
- Class A: Regular common stock with one vote per share.
- Class B: Held by founders with 10x votes compared to class A.
- Class C: Held by employees carrying no voting rights.
Google’s Class B stock above is a good example of supervoting stock. This is the process of assigning founders, key decision makers, and long-term investors a different class of stock that carries supervoting rights compared to average shareholders.
This can be important for fending off activist shareholders seeking to derail the company’s long-term competitive strategy for the sake of more profits in the short term.
Since our audience is typically composed of brilliant-minded investors and entrepreneurs, it’s worth mentioning that advisory shares, usually given to industry thought-leaders, consultants, and others, are typically offered in the form of common stock options.
These essentially offer advisors the right, but not obligation, to purchase shares of the company at a discounted price in the future. Advisory shares are usually given in exchange for consulting and guidance for young companies in lieu of formal payment.
Common Sense is Preferred
Whether you are building value in business or wealth through investing in companies, you should deeply understand how the various investment vehicles of private and public companies differ.
Now that you have a baseline understanding of common stock and preferred stock, continue to research companies that issue and offer each. Understand your tolerance for risk and also get a sense of the potential for and likelihood of rewards.
If you are investing in companies that are currently private, you could see the full lifecycle of the various forms of stock if the company goes public and your preferred shares convert to common.