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Startups generally issue two types of shares—common and preferred. In venture investing—especially at the earliest stages—investors typically negotiate for preferred shares. Meanwhile, founders and the company’s employees usually receive common shares.
Why is this the case? What are the benefits of preferred shares that make them the desired share class for venture investors?
In this guide, we’ll compare preferred shares vs. common shares in the context of venture investing and share examples demonstrating exactly why venture investors usually ask for preferred shares.
The role of preferred shares in the private markets (like venture investing) is quite different compared to their role in the public markets.
In venture investing, investors typically receive preferred shares of the companies they back, while founders and employees receive common shares. The investor’s preferred shares may convert into common shares at some future liquidity event, like an IPO or acquisition (the specifics of what happens upon a liquidity event will be spelled out in the term sheet and, after the round closes, in the startup’s corporate documents).
Both types of shares—preferred and common—grant the holder partial ownership rights of the company. However, preferred shares also confer certain key benefits for investors. For example, preferred shareholders might get paid ahead of common shareholders if the company fails or they might get protected from getting overly diluted as a result of future fundraising rounds.
Startup investors often come in as minority shareholders, meaning their shareholding percentage alone will not give them control over the direction of the company. With preferred shares, however, they can gain certain privileges over common shareholders that allow them to both exert a level of control over the company and limit their downside risk.
The key benefits of preferred shares include:
“The Series A Preferred shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except(i) [so long as [insert fixed number, or %, or "any"] shares of Series A Preferred are outstanding,] the Series A Preferred as a class shall be entitled to elect [_______] [(_)] members of the Board (the "Series A Directors"), and(ii) as required by law.”
One of the most important benefits of preferred shares is their liquidation preferences. These don’t just mean that preferred shareholders get paid out ahead of common shareholders in the event of a bankruptcy or liquidation. The preferred shares’ liquidation preference can also dictate the amount that preferred shareholders would receive upon liquidation.
There are two types of liquidation preferences—participating and non-participating. In a participating liquidation preference, preferred shareholders would receive both their liquidation preference (a contractually specified return multiple) and a pro-rata share of any remaining funds along with the common stockholders. In a non-participating liquidation preference, they can choose either one, but not both.
Here’s an example that shows how both types of liquidation preferences can help protect an investor’s downside.
Assume an investor invested $1M in a company at a $4M pre-money valuation. This would equate to a $5M post-money valuation, with the investor now owning 20% of the company (the founders and employees own the remaining 80%). Let’s suppose the investor received preferred shares in return, with a 2x liquidation preference.
Unfortunately, some time later, the company fails and has to be sold for only $3M.
If those preferred shares had participating liquidation preferences, the investor’s total proceeds from the sale would be $2.2M, which breaks down as follows:
Total proceeds = Liquidation preference + Percentage share of remaining proceeds
= (2 x $1M) + [Ownership percentage x (Total Sale Price – Liquidation preference)]
= $2M + [20% x ($3M - $2M)]
= $2M + $0.2M
In the case of a non-participating liquidation preference, the investor can either choose to take their liquidation preference of $2M, or receive $0.6M (being 20% of the total sale price of $3M). In this instance, they would take their $2M liquidation preference.
This means the common shareholders would be left with either $0.8M or $1M of the $3M—even though they own 80% of the company. Meanwhile, the preferred shareholder got at least double their money back. This is how liquidation preferences can protect an investor’s downside risk.
As previously mentioned, founders and employees typically hold common shares.
For employees, common shares have a few benefits:
As for founders, there are a couple reasons they take common shares instead of preferred shares:
Finally, remember that not all preferred shares are created equal. Investors in different financing rounds may receive preferred shares with different privileges. Investors in later rounds may also ask for specific privileges accorded to earlier investors to be renegotiated—such as anti-dilution protection.