What are common stocks and preferred stocks?

There are many different types of equity instruments to choose from and the most commonly issued ones for start-ups are common stocks and preferred stocks.

While both common and preferred stocks represent the equity ownership of a company, they serve different functions and offer different benefits to shareholders.

Common stock is the simplest form of stock and is generally issued to founders and employees, while preferred stock grants shareholders special privileges, including priority in dividends and in capital returns during an exit or liquidation.

Before issuing any shares, founders need to understand what the difference between these two equity instruments are.

What are common stocks?  

Common stocks are issued during a company's incorporation and represent the ownership structure, which facilitates decision-making and day-to-day activities.

The amount of common stocks issued to each founder usually differs according to the amount of contribution and how much they bring to the table. Hence, founders that are more involved in running the company will receive greater compensation for their effort by having more common stocks.

Do common stock shareholders have voting rights?

Common stocks also come with voting rights, and common stockholders have the right to vote for company decisions such as electing the board of directors.

How are common stocks valued?

The value of common stocks comes from the fact that their price can increase significantly over time as the company grows bigger and becomes successful. Common stockholders will be able to sell their stocks at a high price during exit and this creates a huge return on investments for founders and employees.

The downside is that common stocks usually have no liquidation preference. This means that common stockholders will be the last to receive pay-out upon liquidation of the company during exit or winding up.

Common stock is for Friends , Families & Employees.

Advantages of common stocks

Here are the advantages of common stocks.

• Greater long-term growth potential: Common shares typically provide stronger long-term price appreciation than preferred shares.

• Accessibility: Common stock is generally more accessible to investors because it is issued by a greater number of companies compared to preferred stock.

• Voting privileges: Owners of common shares generally have voting privileges on corporate matters.

Disadvantages of common stocks

Here are the disadvantages of common shares.

• Reduced priority in liquidation events: In liquidation, common stockholders have a lower claim to company assets than preferred shareholders.

• Limited dividend priority: If you hold common shares, you may receive dividends, though these payouts are not assured. Preferred shareholders take priority, so you collect any remaining dividends after they have been paid.

• Higher volatility: Common stock exhibits greater price volatility than preferred stock, leading to pronounced short-term swings. This heightened volatility frequently correlates with enhanced long-term growth and return prospects.

What are preferred stocks?

Preferred stock, as the name suggests, gives shareholders special rights such as preferences to dividends, preference to return of capital upon exit or winding up and more.

Who gets preferred stocks?

Preferred stocks are usually issued to investors during funding because investors demand certain rights including priority during liquidation. Preferred stocks may also be converted into common stocks whereas common stocks do not have this benefit.

Furthermore, if a company misses any dividend payment to the preferred stockholders, it must pay any arrears to preferred stockholders before paying out the common stockholders.

Investors typically will prefer to invest in convertible preference securities which gives them superior rights to common stockholders, priority in terms of payout upon liquidation as well as ability to convert and participate in the upside.

Advantages of preferred stocks

Here are the advantages of preferred stocks.

• Reduced swings in market value: Compared to common stock, preferred stock typically exhibits lower price volatility. Its price tends to remain stable and less sensitive to short-term market swings, making it appealing to risk-averse investors. This steadiness is largely attributed to consistent dividend payments that bolster the stock’s overall value.

• Higher claim in liquidation: Preferred shareholders have priority over common shareholders in receiving assets if a company goes bankrupt or is liquidated. This priority offers greater security, particularly in challenging economic times.

Disadvantages of preferred stocks

• Liquidity concerns: Selling preferred shares may be difficult if there are not enough buyers in the market when you wish to exit.

• No voting rights: Preferred shareholders do not have voting rights. Unlike common shareholders, they cannot participate in decisions such as electing the board of directors or approving major mergers and acquisitions. This is a disadvantage for those who value influence over the company’s direction and governance.

• Reduced scope for significant price appreciation: Preferred stock provides limited opportunities for capital appreciation. Its price typically remains stable, enabling investors to receive consistent dividends but seldom resulting in substantial long-term growth. In contrast, common stock has the potential for significant value increases when a company performs well.

Differences between common stocks vs preferred stocks

Both common stocks and preferred stocks have their pros and cons. Understanding the difference between common stock and preferred stock is essential as they have different purposes and different investors may have different preferences.

Why is Qapita the best equity management platform?

Qapita makes equity management simple for startups. Easily issue and manage both common and preferred stocks, handle vesting and exercises for employees, and keep your investors informed with regular equity updates. Manage your company’s equity with confidence and clarity using Qapita.

Book a demo to see Qapita simplify equity management.

Frequently asked questions

1. Is common stock the same as shares outstanding?

No, common stock and shares outstanding are not the same thing, though they are related. Common stock refers to the type of security (representing ownership), while shares outstanding refers to the number of those shares currently held by investors.  

2. Does common stock have any special preference in either receiving or in bankruptcy?

No, common stock does not have any special preference in either receiving or in bankruptcy.

3. How is fair market value determined for common vs preference stocks?

Fair market value (FMV) for common stock is determined based on the company's total equity value minus preferred liquidation preferences (often via 409A valuations for private firms), while preferred stock FMV is determined like a bond, focusing on dividend yield, liquidation rights, and conversion potential.  

4. Is contributed capital the same as common stock?

Yes, common stock is a primary component of contributed capital (also known as paid-in capital). It represents the total amount of cash or other assets shareholders have given to a company in exchange for stock, specifically recorded at the par or stated value, along with any additional paid-in capital (APIC).  

5. What is the difference between common stock and preferred stock?

Preferred stock acts like a hybrid of bonds and stocks, offering fixed dividends and higher priority claims on assets, suitable for income-focused investors. Common stock represents ownership with voting rights and higher growth potential, suited for long-term capital appreciation despite higher risk and volatility.

6. Why would a company issue preferred shares instead of common shares?

Because preferred stock is built more for fixed dividends and higher priority in liquidation, while common stock is built more for capital appreciation and voting rights.

7. Who usually owns preferred stock?

Private companies typically issue preferred stock to investors, including venture capitalists, angel investors, and private equity firms, during a funding round.