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Whether you’re an employee, a founder, or an investor, it’s essential to understand the difference between common and preferred stock. Let’s discuss both in this article.

1. Introduction
2. What is common stock?
3. What is preferred stock?
4. Understanding the differences: Common Stock vs. Preferred Stock
5. Key Advantages and Disadvantages of Common Stock
6. Key Advantages and Disadvantages of Preferred Stock
7. Which is better: Common Stock or Preferred Stock?
8. The Next Step

Introduction

It’s common to be confused about startup equity, and it makes sense why. The initial valuation of your startup plays a massive role in determining who ends up with what percentage of the company in the end (i.e., your company’s exit). You might hear common stock, preferred stock, and convertible debt thrown around by your friends or read about them online, but chances are you don’t know what they mean. Well, wonder no more, because this article will explain everything you need to know about startup equity to make intelligent investment decisions and protect yourself from bad ones.

This article will clarify the distinctions between common stock vs. preferred stock and explain when each type might be better for an entrepreneur. So, let’s start.

What is Common Stock?

A common stock gives a person a share in a company’s profits and assets. This means that, unlike preferred stock, which typically has no fixed dividend or voting rights, it has more risks. While risk is associated with this route, if you manage to be successful in your startup, you make a lot more money with common stock than with any other type of investment. You can buy and sell common stocks on exchanges just like you would on Wall Street.

For example, if you own 10% of a company’s common stock, you will have 10% of its voting power. This investment strategy is typical for venture capitalists and angel investors betting on startups with high growth potential and not yet established themselves.

What is Preferred stock?

Preferred stock is a hybrid security with debt and equity characteristics. It is senior to common stock, which means it gets paid off before distributing any dividends to common shareholders. It’s also usually cumulative, meaning if a company misses an interest payment on its preferred shares, it must pay back all previously missed costs plus interest before continuing with business as usual.

Preferred stock is an excellent option for investors who want a high rate of return but are willing to give up some control over their investment in exchange. This makes it ideal for venture capitalists, angel investors, and other high-risk, high-reward investors.

Understanding the differences: Common Stock vs. Preferred Stock

The first thing to understand is that startup equity isn’t a one-size-fits-all proposition. Every startup will have different needs and concerns, so every founder’s equity package will be unique. However, you can receive two main types of stock as an employee or founder of a startup: common stock and preferred stock.

Preferred stockholders are generally first in line to receive dividends and have a higher priority in the event of bankruptcy. On the other hand, common stockholders are last in line to receive dividends and may not receive anything if the company declares bankruptcy. Here’s how they differ, along with some pros and cons for each type of stock option.

Basics	Common Stock	Preferred Stock
Voting Rights	Has voting rights	No voting rights
Liquidation	Has the slightest claim on the profits and assets of a firm.	Only bondholders have a higher claim on a company’s profit and assets.
Conversion	It cannot be converted to preferred stocks.	It can be converted to a certain number of common stocks.
Dividends	May be paid basis the board’s decision.	Are paid out in two ways- fixed and cumulative.
Returns	Depend on the share price appreciation or depreciation, as well as the optional dividend.	Depends on its dividends.
Claim to Earning	Common stockholders are paid out last.	Preferred stockholders are paid out second to bondholders.
Certainty	No profits mean no dividends	Pays dividends even if the company bears losses.
Stockholders	Owned by the general public, employees, etc.	Ownership is within the issuing company.

Key Advantages and Disadvantages of Common Stocks

The critical advantage of common stock is that it represents ownership in a company and entitles the holder to a share of its profits. In addition, common shareholders have a vote in corporate decisions, and as a result, they can have a say in how the company is run and have a financial stake in its success. Another advantage of owning common stock is that it typically provides greater liquidity than other investment forms, such as bonds.

Let’s look at the specific advantages and disadvantages of common stock.

List of the Advantages of Common Stocks

• Higher Earning Potential: When it comes to investment opportunities, common stock is often seen as a more favorable option than other choices, such as bonds or preferred stock. This is because common stock usually offers a higher potential for earnings growth and, therefore, a higher potential for return on investment (RoI). Additionally, common stockholders typically have a voice in how the company is run, which can result in a better return on investment in the long run.

• Provide Dividends: A company’s common stock can provide dividends to its shareholders. A dividend is a distribution of a company’s earnings, usually expressed as a percentage of the share price. The dividend amount can vary depending on several factors, including the company’s profitability and financial condition. Generally, dividends are paid out to shareholders regularly, such as quarterly or annually.

• Tackle Inflation Problems: The primary benefit of owning common stock is that it offers a way to avoid inflation problems. This is because the stock prices tend to rise faster than the rate of inflation, so investors can preserve the purchasing power of their money by investing in stocks. Investors need to predict which stocks will outperform the inflation rate to take advantage of this benefit.

• Various trading ways: There are several ways that you can trade common stocks. You can buy and sell them on the open market, use a broker to do it for you, or use an online trading platform. You can also invest in ETFs or mutual funds that contain stocks.

• Advantage of growth: When a company is doing well and experiencing rapid growth, its common stock can provide shareholders with the opportunity to participate in that growth. The price of common stock typically rises as the company becomes more successful, so shareholders who sell when the stock is high can make a profit.

List of the Disadvantages of Common Stocks

• High Competition: When investing in common stocks, an individual is likely to face high levels of professional competition. This is because the stock market is a very liquid and efficient market, which means that there are many participants and that prices quickly adjust to reflect new information. This makes it difficult for individual investors to “beat the market” by making wise investment choices. Instead, most successful investors focus on creating a well-diversified portfolio that can withstand short-term price fluctuations.

• Takes time for significant gains: The common stockholder has a long wait for significant gains, as dividends are not paid out as quickly as other investments, and the stock does not appreciate as rapidly as other options. Additionally, common stockholders are last in line to receive company assets if the company goes bankrupt.

• Lack of control: The main disadvantage of common stock is that shareholders don’t have much control over their investment. For example, they cannot decide who manages the company or what its strategic goals should be. Additionally, if the company experiences financial trouble, shareholders may not receive any money back from their investment.

Key Advantages and Disadvantages of Preferred Stock

A preferred stock has a combination characteristic of stock that pays fixed dividends alongside the equity component that makes investment decisions more viable since equity tends to enlarge. Preferred stock is considered the favorite of many investors owing to its dividend security feature.

When you are in the market for an investment, you ought to look at the best of these advantages and disadvantages.

List of Advantages of Preferred Stock

• Preferred stockholders are prioritized: Preferred stockholders are typically guaranteed a fixed dividend payment from the company’s profits each year. This payment is made before common stockholders receive dividends, making it a preferential return on investment. Preferred shareholders also have a higher claim on the company’s assets in the event of bankruptcy or liquidation. For these reasons, preferred stock is often seen as a more secure investment than common stock.

• Provides Cumulative shares: Some kinds of preferred stock allow investors to pick cumulative shares. This is a type of preferred stock that mandates that if dividends have been revoked or not paid in the past, they must be paid out to cumulative preferred shareholders first before any of it goes to shareholders holding common stock. Thus, if given an option, investors can seek the ideal stock to add to their portfolio, by investing in cumulative shares in particular.

• Higher claim on company’s assets: Preferred stocks give investors a higher claim on any company assets than common stocks. This means that if the company goes bankrupt, the holders of preferred stock will be paid back before the holders of common stock. Preferred stocks also tend to have a higher dividend yield than common stock, meaning that you will get paid more in dividends if you own preferred stock than if you own common stock.

List of Disadvantages of Preferred Stock

• No Voting Rights: Preferred stockholders are not typically given voting rights, as they are not considered shareholders in the same sense as common stockholders. This is because their ownership stake in the company is subordinate to common stockholders, and they do not have a right to vote on company matters. In some cases, preferred shareholders may be granted limited voting rights, but this varies between companies.

• Challenges in maturity time: Like bonds, preferred stocks are typically structured similar to fixed-income securities today. Some have a specific maturity date, at which point the company will redeem the equity for cash at a predetermined price. For the most part, chosen stocks tend to react to interest rates similarly to bonds. Hence, an amateur investor must be aware of any applicable time-to-maturity stipulations for their favored investment.

• Limited upside potential: Like other more conservative investments, the potential for gains associated with preferred stock is limited. The specific amount of dividends that the investment can pay investors will usually be specified in the financial documents related to the acquisition. For this reason, investors need to determine if their preferred stock yields are competitive before investing in one of these securities.

Which is better: Common Stock or Preferred Stock?

Both common stock and preferred stock have long histories and different features. While common stocks give owners voting privileges, preferred stocks extend no such rights to their shareholders.

When deciding to capitalize on a particular bit of assets, an investor must consider and decide on a project’s funding purpose. For example, if you are investing to get a steady income that is relatively risk-free, you can invest in preferred stocks on the grounds of the default claim at the time of dividend payment and/or insolvency.

On the other hand, if you are investing with the expectation of gaining high value and possibly incurring a higher level of risk, you can do that by purchasing common stocks. Additionally, you may choose to invest in common stocks if you want to serve as a shareholder that receives voting rights and an introduction to the board of directors.

The Next Step

Entrepreneurs have huge responsibilities, as they must make the right decisions at some costs. The longest part of being an entrepreneur is figuring out which way to take your company and get your investment. And it’s essential to choose the right type of equity to offer potential investors. Different types of equity offer various rewards, and your kind of equity may be more valuable to one investor, depending on their goals and expectations.

But once you do, the ride will be a fantastic experience. A well-written equity financing plan can help you, as it is the blueprint for every successful business.

It is also a good idea to seek professional advice from an accountant and a financial advisor, as they can help you with the most intricate issues related to tax laws and other economic and regulatory matters. Ensure your decision before reaching the deep end because time is of the essence. The longer you wait to make your choice, the harder it is to make a change.