Common Stock vs. Preferred Stock: The Difference That Changes Everything

The two types of startup shares

There are only two classes of stock in most startups: common stock and preferred stock. But these two words conceal a massive difference in rights, value, and what happens to your shares at exit.

Most startup employees own common stock. Most venture investors own preferred stock. That difference is arguably the single most important thing any startup shareholder should understand, because it determines how much of the company's exit value actually flows to you.

Common stock

Common stock is the basic form of equity ownership. When you own common shares, you own a piece of the company, pro rata. If you own 1% of the company in common stock, and the company is sold for $100 million, your 1% entitles you to $1 million.

That sounds straightforward. But there's a catch.

Common shareholders only get paid after preferred shareholders have been paid. And preferred shareholders almost always have special rights that significantly change the payout waterfall.

Common stock typically comes with voting rights. You get to vote on major company decisions, board seats, and liquidation events. But in most startups, the preferred shareholders control the board and have special voting agreements that severely limit the power of common shareholders.

Common stock is what most startup employees get in the form of options or RSUs. It's also what founders usually own (though founders often hold both common and sometimes preferred stock, especially if they've gone multiple rounds).

Preferred stock

Preferred stock is what venture investors buy in funding rounds. It's preferred because it has special rights that common stock doesn't have.

The most important right is the liquidation preference. This is a priority right - when the company exits, preferred shareholders get paid before common shareholders.

The second important right is anti-dilution protection, which protects preferred investors from getting diluted if the company raises money at a lower valuation in the future.

Preferred stock usually also comes with board seats, information rights, and control over major decisions like raising money, acquisitions, or selling shares.

How liquidation preferences work

A liquidation preference is usually stated as a multiple of the investment amount. The most common is a 1x liquidation preference, which means preferred investors get their money back first (1x what they invested), and then any remaining cash goes to common shareholders.

Here's a concrete example:

This is the waterfall effect. Money flows down in layers. Preferred shareholders get paid from the bottom of the waterfall, common shareholders get whatever's left at the top.

In that example, the Series A investors' preference made sense - they got their money back. But in many acquisitions or down rounds, common shareholders can get paid nothing, while preferred shareholders still get significant returns.

This doesn't mean preferred investors are evil or common shareholders are doomed. It means you need to understand where you sit in the waterfall to know what your equity is actually worth.

Why VCs always get preferred stock

Venture capitalists always insist on preferred stock for a simple reason: risk mitigation. They're writing large checks and want downside protection.

If a venture investor bought common stock and the company had a down round or a modest acquisition, they could lose money. With preferred stock and liquidation preferences, they get at least their money back before common shareholders are paid anything.

For founders and employees, common stock is the norm because it's less expensive to grant (no special rights to negotiate), and because the upside if the company does well is enormous. If the company is acquired for $500M and common shareholders own 40%, they get $200M to split. That's life-changing money.

But if the company is acquired for $50M, and preferred investors have $60M in liquidation preferences? Common shareholders might get nothing.

Why the headline valuation is misleading

When your company announces it raised Series B at a $500M valuation, that number doesn't tell you what your common shares are worth.

That $500M valuation is the post-money valuation set by the preferred investors buying in that round. It's based on what they think the company could be worth at exit. It has nothing to do with the claim structure or what actually gets paid to different shareholders.

The $500M valuation might imply that a 0.5% common shareholder (a typical employee grant) is worth $2.5M. But that's only true if:

• The company actually exits above the sum of all liquidation preferences.
• The preferred shareholders don't exercise any additional rights that change the payout order.
• There are no down rounds or lower acquisitions that eat into common equity.

In practice, you need to know your company's cap stack - who owns what, what are their liquidation preferences, and what happened in each funding round - to have any real sense of what your common shares are worth.

Participation rights (the plot thickens)

Preferred stock sometimes has a feature called a "participation right" (or a "non-participating preference"), which changes how the waterfall works.

With a non-participating preference (1x), preferred investors get paid their liquidation preference amount, and then the rest goes pro rata to all shareholders based on ownership.

With a participating preference, preferred investors get both their liquidation preference AND then participate in any remaining proceeds on a pro rata basis. This is worse for common shareholders - it means preferred investors get paid twice, effectively.

Most early-stage preferred stock is non-participating. But if your company has multiple rounds or complex financials, there might be participating preferences, which further reduces what common shareholders get.

What this means for secondary transactions

This is where Earlyasset comes in. When you're looking to sell your common shares in the secondary market, the buyer (whether it's Earlyasset Capital or another investor) needs to understand your cap stack and the liquidation preference structure.

The price you can get for your shares depends on a waterfall analysis - what happens if the company exits at various valuations, and what cash actually flows to common shareholders at each scenario.

If you own common shares and the company has a lot of senior liquidation preferences, your shares might be worth less than the headline math suggests. But they're still worth something - the question is what that something is in the current market.

That's what price discovery does. It answers the question: given the cap stack, the company's trajectory, and secondary market data, what would someone pay for your shares right now?

The key questions to ask yourself

1. Do I hold common or preferred stock? Ask HR or your equity documents. Employees almost always have common stock.

2. What are the liquidation preferences in my company's cap stack? Your cap table shows this. If you can't see your cap table, ask for a summary of senior liquidation preferences.

3. At what valuation do common shareholders start getting paid? This is the sum of all liquidation preferences. If that number is close to your last funding round valuation, your shares are riskier than the headline math suggests.

4. What would my shares be worth if the company exits at 1.5x, 2x, 3x the last funding round? This waterfall analysis tells you the real value distribution.

Understanding common vs. preferred stock is the foundation for understanding what your equity is actually worth. The next step is getting a price discovery from a credible source - which means analyzing the cap stack and running a waterfall to see what you'd actually receive in various scenarios.

This article is provided for informational purposes only and does not constitute investment, legal, or financial advice. The value of private company shares depends on many factors specific to each company and transaction. Earlyasset, Inc. is not a registered investment adviser. Consult qualified professionals before making any financial decisions involving private securities.