Common vs. Preferred Stock: Everything Investors Should Know

Equity ownership lies at the heart of every business. But not all shares are created equal. For investors navigating the private markets, or founders structuring their cap tables, understanding the distinction between common stock and preferred stock is essential. Each carries a unique set of rights, priorities, and strategic implications that can materially affect outcomes across funding rounds, exits, and distributions.

• Common vs. Preferred Stock: Everything Investors Should Know
  • What Is Common Stock?
    • Mechanics
  • What Is Preferred Stock?
    • Mechanics
    • Types of Preferred Stock Provisions
      • 1. Participating vs. Non-Participating Preferred
      • 2. Convertible vs. Redeemable Preferred
      • 3. Cumulative vs. Non-Cumulative Dividends
  • Key Differences at a Glance
  • Strategic Implications for Investors

What Is Common Stock?

Common stock is a type of security that represent basic ownership in a company. These stocks form the foundation of a company’s equity and is often the most widely held class of shares. Founders, early employees, and retail investors typically hold common stock, especially in startups and growth-stage companies.

Mechanics

Employees typically receive stock options through an equity incentive plan. These options grant them the right to purchase shares of common stock at a predetermined price, known as the strike price. When an employee chooses to exercise their options, the company issues the corresponding number of common shares to them.

Common shares usually rank last when it comes to receiving proceeds in a liquidation event, as creditors and preferred shareholders are paid first during situations like mergers, acquisitions, or IPOs. Only after these obligations are met do common stockholders receive any remaining assets. Because of this lower priority, and the lower likelihood of returns in an exit event, common stock is considered a riskier investment. However, if the company’s value increases significantly or it is acquired at a higher price, common stockholders stand to gain substantial financial rewards.

What Is Preferred Stock?

Preferred stock is a type of equity security that combines characteristics of both debt and equity. It is often issued to institutional investors, venture capitalists, and private equity funds as part of a negotiated financing round. While preferred shareholders typically do not control a company outright, they benefit from enhanced economic rights and downside protections compared to common stockholders.

It is designed to protect invested capital while still allowing for upside participation through convertibility features.

Mechanics

Preferred stock is typically issued during venture or growth equity rounds and may be customized to align investor protections with company-stage risk. One of the core advantages of preferred shares is the liquidation preference, a contractual right that entitles investors to recoup their investment (often 1x, but sometimes 1.5x or 2x) before any proceeds are shared with common stockholders.

Depending on the terms, preferred shareholders may also receive dividends – fixed payments distributed before any dividends are paid to common shareholders. While these are often deferred or unpaid in growth companies, they accrue on the balance sheet and impact the waterfall at exit.

Additionally, preferred shares may include convertibility clauses, allowing investors to exchange their shares for common stock, typically at a predetermined ratio. This conversion is often automatic in events like IPOs or strategic acquisitions to simplify the cap table.

Types of Preferred Stock Provisions

1. Participating vs. Non-Participating Preferred

• Participating preferred shareholders receive their liquidation preference and a share of the remaining proceeds as if they had converted to common, potentially leading to outsized payouts.
  
• Non-participating preferred shareholders must choose: take the liquidation preference or convert to common to participate in the upside.

Participating structures are often viewed as investor-friendly and are more common in earlier-stage or higher-risk deals. Later-stage companies may negotiate non-participating terms to preserve more upside for common holders.

2. Convertible vs. Redeemable Preferred

• Convertible preferred shares can be voluntarily or automatically converted into common stock, especially in exit events like IPOs or M&A.
  
• Redeemable preferred shares (sometimes called straight preferred) can be repurchased by the company after a certain date, often at the original issue price plus any accrued dividends.

Convertible preferred is dominant in venture capital, where long-term upside is a key driver. Redeemable preferred appears more often in private credit or structured equity.

3. Cumulative vs. Non-Cumulative Dividends

• Cumulative preferred shares accrue unpaid dividends over time. If a dividend is missed, it accumulates and must be paid before any common stock dividends.
  
• Non-cumulative preferred shares do not accumulate unpaid dividends—if the board skips a payment, it is permanently forfeited.

Cumulative dividends are common in investor-friendly structures where return thresholds matter (e.g., PE-style pref equity), while non-cumulative structures may be seen in more founder-friendly environments.

Key Differences at a Glance

Strategic Implications for Investors

For allocators and private investors, understanding where and how these share classes fit within the capital stack is critical:

Risk-return profile:
Common stock offers greater upside but less protection. Preferred shares provide contractual safeguards that can reduce downside risk.

Exit dynamics:
In a successful IPO, preferred shares often convert to common. But in a down-round or fire sale, preferred holders may recover capital while common shareholders get nothing.

Governance and control:
While preferred stock may come with special veto rights, it often lacks broader voting power, unless negotiated otherwise.

Dilution sensitivity:
Preferred terms like full-ratchet or weighted average anti-dilution can significantly alter ownership and value allocation across cap table participants.

As Carta notes, “Preferred stock is favored by investors looking for some protection on their capital, especially in early-stage or illiquid companies.” By contrast, common stock reflects long-term belief in the company’s upside potential, often without contractual guarantees.