Common Vs. Preferred Stock for Financing a Private Company

Most business owners are familiar with traditional debt financing through bank loans. Many also have heard the term "venture capital" or "angel investment" but are unfamiliar with equity financing. Equity financing occurs when a business issues stock, providing an ownership stake in the business in exchange for funding. Potential equity investors include venture capitalists, angel investors, partners and large customers. Companies can issue common stock or preferred stock.

Purchasers of preferred or common shares in a corporation have an ownership stake in that company. In exchange for issuing stock, a company receives needed cash to fund organic growth, make acquisitions or retire debt. The new shareholders believe in the company's growth potential, and their investment allows them to participate in that growth and reap benefits through dividends and capital gains. Shareholders believe the opportunity to double or quadruple their investment outweighs the risk of a total or partial loss of their investment.

Although both common and preferred stock provide ownership and residual claims on a company, a number of differences exist between the two. Preferred shareholders receive preferential treatment when it comes to distribution of the firm's assets, including cash. Preferred shareholders receive dividends before common shareholders. A company cannot pay dividends to common shareholders until the preferred shareholder dividends are fully paid. If the business fails, preferred shareholders will be paid after creditors but before any common shareholders.

Common stock provides full voting right to its holders. However, a company can divide common stock into tranches, or classes, and vest one tranche with more voting rights than another. Private company founders may do this to retain control of the company even as their equity stake decreases. Preferred stock usually provides limited or no voting rights. Preferred shareholders can often vote only if the company did not pay dividends. Venture capital firms circumvent this and demand voting seats on the board by owning a special form of preferred stock called participating preferred shares.

A company's common stockholders have the highest risk, so they usually enjoy the greatest rewards if a company significantly increases in value. Preferred stockholder gains typically are capped at the return of principal and dividend payouts. Often when preferred shareholders receive guaranteed dividends, they receive no or limited additional compensation when a company is sold. Participating preferred shares differ. After the company fully repays principal and dividends to participating preferred shareholders, these shareholders convert their shares to common shares and fully reap the benefits of the buyer's high valuation.