What is the difference between common stock and preferred stock?

TLDR: Common stock is typically issued to founders and employees while preferred stock is issued to investors. The preferred stock will reflect the special rights and privileges that investors negotiate for when they invest.

Common stock and preferred stock both represent equity ownership interests of a company. However, preferred stock will typically have special rights exclusive to the preferred stock or a particular series of preferred stock. In general, founders will hold common stock and investors will hold preferred stock. Stock options for employees and consultants of a company will typically be exercisable into common stock.

Preferred stock is usually divided into different series based on different preferred stock financing rounds (e.g., Seed and Series A preferred stock financings, etc.). Common stock is typically a single series (or class) but can be divided into multiple classes with different rights, most often with different voting rights. Other important topics to consider concerning common stock and preferred stock include the following:

• Liquidation Preference: A liquidation preference is the right to receive a specified amount prior and in preference to other holders of a company’s capital stock in the event of a sale or liquidation of a company. The preference amount is usually equal to an investor’s original investment, but other multiples of an investor’s original investment may be used. The liquidation preference can either be paid to the holders of all series of preferred stock on a pro rata basis or priority can be given to particular series of preferred stock. In the latter case, a more recent series of preferred stock may be given priority to an existing series (e.g., the preference for the Series A preferred stock being paid in full prior to the preference for the Seed round). The current trend is for investors to receive the better of their liquidation preference or participation with a company’s common stockholders on an as converted to common stock basis upon a sale or liquidation. This is known as a non-participating liquidation preference since the preferred stock does not participate in the distribution of the company’s assets after payment of the preference. However, preferred stock can also have a participating liquidation preference and receive both its liquidation preference and participation with the common stockholders in the distribution of the company’s remaining assets.
• Protective Provisions (Voting Rights): Preferred stock may have special voting rights that are not afforded to the holders of a company’s common stock, known as protective provisions. These rights can be granted to all holders of preferred stock or unique to a particular series of preferred stock. A protective provision will require a certain percentage of the holders of the company’s preferred stock to approve major actions by the company. Common protective provisions include:
• amending certificate of incorporation or bylaws;
• authorizing a new series of common stock or preferred stock;
• sale or liquidation;
• declaring a dividend payment;
• increasing or decreasing number of directors; or
• entering into related party transactions with officers or directors of a company.
• Director Elections: The holders of preferred stock will often be entitled to elect one or more directors to a company’s board of directors. This allows the company’s investors to be represented on the board, along with the founders and other independent board members not directly affiliated with the founders or investors. The right to elect a board seat may be specific to a series of preferred stock or to all series of preferred stock collectively. If the right is specific to a series of preferred stock, the largest stockholder of the series typically has the ability to appoint the director on behalf of the series.
• Pro Rata Rights: A pro rata right is a right of first refusal in favor of the holders of preferred stock over new issuances of a company’s capital stock. The right is referred to as a “pro rata right” since investors have the ability to purchase a number of the newly issued shares of the company’s capital stock up to their pro rata share of the company’s existing capital stock.
• Conversion into Common Stock: All preferred stock will have a right to convert into shares of common stock, usually on a one-for-one basis. The conversion to common stock is often voluntary, except in the case of a sale or an IPO.
• Anti-Dilution Rights: Most preferred stock will have some form of anti-dilution protection, which is the right to receive more shares of stock in the event that a company sells shares of its stock in the future at a lower price than the preferred stock. The additional shares, or the right to receive additional shares on conversion of the preferred stock to common stock, compensate the holders of preferred stock for the dilutive effect of the lower-priced stock.

In the event of a dilutive issuance, the conversion ratio between preferred stock and common stock will be adjusted such that each share or preferred stock will convert into more than one share of common stock. This allows the liquidation preference for each holder of preferred stock to remain unchanged, as the preference is tied to the number of shares of preferred stock owned, while giving the holder of preferred stock the benefit of more shares on a sale or liquidation of a company with proceeds that exceed the liquidation preference for the preferred stock. There are a variety of ways to determine the change to the conversion ratio, although the most common is known as broad-based weighted-average anti-dilution protection, which takes into account both the number of shares issued and the difference between the original preferred stock price and the newly issued stock price.

• Right of First Refusal and Co-Sale: Significant holders of preferred stock will often have a right of first refusal, second to the company, over shares of common stock held by significant common stockholders, who are often a company’s founders. Additionally, the same holders of preferred stock may also have a right of co-sale, which allows the holders to sell shares of preferred stock, as converted to common stock, in any sale of common stock by a significant common stockholder to a third party, usually on a pro rata basis.

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