As described in a prior note, equity (or stock) is a legal/financial interest in and claim upon the assets of your venture. Equity, or stock, comes in a variety of shapes and sizes. While most startups will not likely encounter the most sophisticated variations of equity, it’s wise to develop a real curiosity in the terms that describe and, therefore, augment what might otherwise be your garden variety of stock.

Common versus Preferred

In a topology of equity varieties the top level distinction in this listing would be that between common and preferred shares. Importantly, either of these classes of equity are nothing more or less than the terms attached to their share agreements. In other words, don’t just assume what you are looking at are truly “common” shares, or “preferred” shares, simply because the title in the agreement says so. Instead, read the agreement very closely and decide for yourself.

Most importantly, unless some sort of legal black magic has been performed, equity holders regardless of the type of share(s) they hold—common or preferred—make their claim on the assets of the firm only after the claims of those holding debt have been settled. Once the claims of debtholders have been settled, preferred shareholders make their claims, followed eventually by common shareholders.

Both common and preferred shares can be issued in groups known as series. Each series of stock is often given its own letter or letter cluster (e.g., Series A common, or Series FF preferred). Any series of stock should have unique characteristics that distinguish that series from another. How these series can differ will be discussed in subsequent notes (like the Preferences of Preferred Shares).

COMMON SHARES

Common shares are considered common because of the position designated to the holders of these shares in relation to those who hold other forms of shares of the company. What makes common shareholders truly “common” is that they can claim their share of the assets of the company only after the claims of preferred shareholders (and debt-holders) have been met.

Common shares may or may not have voting rights, and when they have voting rights these rights may be curtailed in some way. In the wild, there may even be different series of common shares issued by the same company, making some common shares more common than others! For example, five shares of one series A of common stock may equal the vote of one share of a series B of common stock.

While it is commonplace (no pun intended) for the founders and employees to be the only people holding common shares in startups (prior to these shares being sold to the general public through an IPO), this characterization is not always the case. For example, some angel investors may participate as common shareholders and, conversely, some founders/employees may hold preferred shares.

Furthermore, if the company is sold, goes public, or experiences some other sort of liquidity event, the varieties of equity held by different shareholders prior to that event often converge into common shares as part of that event.

PREFERRED SHARES

The range of so-called “preferences” are what give preferred shares their name, and these preferences only exist as compared to the relative lack of similar perks granted to the holders of common shares. The sorts of preferences you might encounter include: guaranteed dividends, cumulative dividends, liquidation, conversion, upgrades, redemption, participation, among others. A variety of these preferences is discussed in the note, The Preferences of Preferred Shares.

Because of the characteristics of these preferences it is often said that preferred shares are a blend of equity and debt—having not only a stake in the assets of the firm akin to that held by equity holders, but also the guarantees of income (in the form of dividends) and position in the liquidation hierarchy akin to that offered to holders of debt.

Startups that engage in multiple rounds of outside equity funding are likely to issue a different series of preferred shares, in particular, at each round of funding (e.g., Series A, B, C, and so forth). The shares within each of these series of “preferreds” should have the same characteristics, while the shares across different series of preferreds tend to have different characteristics.

As a result of these differing series of preferred shares, investors who participate in different rounds of funding may have quite different legal, financial, and even governance relationships with the startup.

Finally, and as you might expect, the characteristics of any series of preferred shares often reflect the differences in bargaining power held by the startup and investors at that moment in time. So-called “hot” startups might negotiate terms that seem far more benevolent than those negotiated by “cold” startups.

Further reading:

Feldman, A. (2007). Putting founders first: How one VC firm coddles its CEOs. Inc.com.