Common Vs. Preferred Stock for Financing a Private Company
First-time entrepreneurs looking to raise capital for a start-up venture may be surprised to learn that most experienced or institutional investors prefer to be issued preferred stock rather than common stock for their investment.
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Higher Level of Protection
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In the event of a bankruptcy, debt holders have first claim to any of the company's assets and property. Next in line are the preferred stockholders. Provided the company carries no long-term debt, investors may want the added safety of having privileges over the common stockholders to any item owned by the company, such as assets, relationships or intellectual property. Investors may demand this preferential treatment prior to committing funds to the organization to help offset the risk associated with investing in a start-up.
Covenants
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Akin to the above, preferred stock can be structured to require the company to adhere to certain agreements or stipulations. For instance, if written into the subscription agreement for the investment, preferred stockholders can often prevent the company from executing debt instruments, issuing more shares or raising additional capital without consent of the preferred stock owners.
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Conversion Flexibility
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If the business is successful, the upside of ownership is in owning the common stock of a company. That is, all investors look for the day when their preferred stock can be converted into common stock. In some cases, the preferred stock may automatically convert to common stock once the company reaches certain earnings milestones or after a set amount of time. A benefit of preferred stock is that the conversion terms can be explicitly defined at the time of investment. An investor can also own one share or unit of preferred stock and have that one unit convert into a fixed or variable number of outstanding shares of common stock as defined by the investor agreement.
Identifies Various Financing Rounds
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As a company expands, it may require additional rounds of financing to keep up the rapid growth, to use for a specific acquisition or to stay in business during tough economic times. Often times, each round of financing is identified with a letter, such as Series A, Series B and so forth. Preferred stock is often issued in various classes, such as Class A or Class B to correspond with the specific round of financing. Each class of preferred stock can carry different valuations and covenants and identifying each class by letter helps with organization.
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