Common Stock vs. Preferred Stock in Venture Funding Transactions

I get the same question a lot from entrepreneurs raising equity capital (venture capital or angel funding).

The question is whether they need to issue common or preferred stock.

The answer depends on how and what rights are defined in the preferred stock.  One very popular "preferred right" or "preference" that adds very significant value to outside investors and is common in venture capital investments is a liquidation preference.

The liquidation preference means what is sounds - namely that preferred stock holders with this right get all of their money back (i.e. liquidate their shares) before any distribution of proceeds in the event of a sale of a company.  This is an extremely valuable preference that can best be shown by example.

Let's say an investor buys 1,000,000 shares of stock in a company at $5/share and the company's total shares outstanding is 3,000,000 shares (implying a pre-money valuation of $10 million (2 million shares @ $5/share) and a post-money valuation of $15,000,000 (3 million shares @ $5/share)).

If, then the company were to be sold for $5,000,000 (i.e. at 1/3 of its original post-money valuation), then if the investor owned common shares (or preferred shares without the liquidation preference), then they would receive back $1,666,666 of their original $5,000,000 investment.

If, on the other hand, they owned shares WITH this liquidation preference, they would then receive their ENTIRE $5,000,000 original investment back. This is obviously a big, big difference to both the entrepreneur and the investor.

So make sure if an investor is offering you funding that you understand the type of stock they want to purchase and the specific rights (such as liquidation preference) that they seek, and negotiate accordingly.