Common Stock vs. Preferred Stock: Pros And Cons For Entrepreneurs by Alejandro Cremades

VCs tend to demand preferred stock when funding a startup. They do so because this class of stock provides them with financial benefits and tends to lower their financial risk if the company were to go bankrupt.

  • How helpful? Scale of 1 to 5

5.

  • Topic Tags

Preferred stock, equity dilution, venture capital investing

  • Relevant questions addressed

What do venture capitalists get in exchange for funding?

What type of equity do VCs prefer?

Why do VCs want preferred stock?

What are the characteristics of preferred stock?

  • Summary bullet points
  • Preferred stock has been attracting more investors, especially large, sophisticated ones investing in early financing rounds.
  • Sometimes the issuer will sell convertible notes, which later can become preferred stock
    • Most terms in a financing agreement are negotiable
  • Preferred stock is favored because it can offer dividends and fixed returns, or otherwise reduce the investment risk to the VCs since they can have anti-dilution provisions and take precedence over common stockholders’ claims
    • Because of these properties, entrepreneurs can fail to realize how much they are giving up in financial and control terms in the event of exits, other financing rounds, or liquidations
    • A bonus of convertible preferred notes is that it is considered to be equity
      • The “dividends” are deductible for tax purposes, as it is debt
      • But the company’s debt level and D/E ratios are left untouched
  • To try to protect themselves, founders have started creating new classes of stock
    • Supervoting stocks are entitled to a set multiple of the votes of other stock classes to allow founders to retain control of their company
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