Differences Between Common and Preferred Stock

There are significant differences between common and preferred stock. Generally, you will want to issue common stock to founders and employees through the employee stock option program and offer preferred stock to investors.

Common stock should be thought of as a vehicle for issuance in exchange for effort, or "sweat equity." Preferred stock has preferential rights in matters such as liquidation and board representation. These are rights generally reserved for those who have invested cash in the business.

So why take on this complexity when you're just a startup? Having common and preferred stock is the simplest way to give preferred investors the protections they'll insist on. You may need to provide these investors the right to co-invest in additional rounds of financing and the right to a co-sale if a shareholder sells their ownership in the business.

Investors may also ask for antidilution protection. This provision protects early investors from having their share of ownership reduced or diluted if subsequent investors invest in the company at a lower price. This essentially guarantees corporate tax investors' investments. All of these provisions can be incorporated into the rights of the preferred stock without requiring complex side agreements.

There are also tax advantages to having two kinds of stock. You want the lowest price per share attributed to the common stock in order to issue it with the least tax consequences to those who work to earn the stock. You want the highest price per share associated with the stock you issue to cash investors. This distinction is important, because investors want the highest possible tax basis without paying more for the investment than its fair value. The common investors want the lowest value attributed so they don't get stuck with a tax liability for the shares they receive. This is one of the key issues for employee stock-ownership programs.

It's not uncommon for the value of preferred-stock shares to be 10 times that of common-stock shares, although ultimately, both types of stock are converted into common shares at the time of the public offering.


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