What's the difference between common and preferred stock?
Many people do not know the difference between common and preferred stock, however, the differences are significant, so it is important to know them.
What are the differences between common and preferred stock?
Just who the stock is issued to shows some of the underlying differences, now let's take a closer look:
When it comes down to it, one of the biggest differences is the liquidity and weight of the stocks. By liquidity, it means how easily they can be turned into cash, and by weight, how much board representation you get for ownership of said stocks.
Common stock is less liquid, and has less pull. It is often thought of as a vehicle for issuance in exchange for effort, or sweat equity. So, in other words, if you work hard we will give you a little stock for doing so, or a piece of the company, but this piece can be difficult to get at, and does not hold much weight.
Preferred stock is more liquid, and has a say. Preferred stock is called just that because it has preferential rights in matters such as liquidation and board representation. This stock is for people who invest cash, not time, into the business.
Ok, so now that you know the differences, let's take a look at why they even exist. You might be asking yourself the question, "Why would a startup company want to worry about something so complex?"
The answer is simple. Having common and preferred stock is the easiest way to give investors (those putting cash, not time or sweat, into your company) the protections they'll insist on. People do not just throw money around, at least not in general, and they are not going to invest in your company unless they have some sort of reassurance or protection. Preferred stock is your way of giving them that reassurance or protection.
Along with what was already discussed about preferred stock, sometimes you also have to give 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.
In addition, some investors may also ask for antidilution protection. What is that? It is a fancy way of saying that because they invested early in your company, before everyone else was, they want their share of ownership protected from the possibility of being reduced or diluted if (or when) other investors invest in the company, but do so at a lower price.
Basically, you may have to cater to your investors some, but the upside is that all these provisions can be incorporated into the rights of the preferred stock. And then you do not have to deal with other contracts, complexities, and agreements. Hence the advantage of offering preferred stock.
Basically to take advantage of these tax breaks, you will want to attribute the lowest price per share to the common stock. This in turn means that those who work to earn the stock have the least tax consequences, as technically stock options are considered income, and you have to pay taxes on them even if you do not have any cash flow come from them.
You in turn want the highest price per share associated with the stock you issue to cash investors.
So, the big difference between common and preferred stock is what the intrinsic values are. Or what is attached, whether that is the tax liability, or the privileges. It's not uncommon for the value of preferred-stock shares to be 10 times that of common-stock shares. However, in the end both types of stock are converted into common shares at the time of the public offering. So, once the company has gone public, there is no difference, it is before that matters.