editione2.1.1Updated September 12, 2022
Definition Investors often ask for rights to be paid back first in exchange for their investment. The way these different rights are handled is by creating different classes of stock. (These are also sometimes called classes of shares, though that term has another meaning in the context of mutual funds.)
Definition Two important classes of stock are common stock and preferred stock. In general, preferred stock has “rights, preferences, and privileges” that common stock does not have. Typically, investors get preferred stock, and founders and employees get common stock (or stock options).
The exact number of classes of stock and the differences between them can vary company to company, and, in a startup, these can vary at each round of funding.
confusion Another term you’re likely to hear is founders’ stock, which is (usually) common stock allocated at a company’s formation, but otherwise doesn’t have any different rights from other common stock.*
Although preferred stock rights are too complex to cover fully, we can give a few key details:
Definition Preferred stock usually has a liquidation preference (or preference), meaning the preferred stock owners will be paid before the common stock owners when a liquidity event occurs, such as if the company is sold or goes public.
Definition A company is in liquidation overhang when the value of the company doesn’t reach the dollar amount investors put into it. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). If investors have put millions of dollars into a company and it’s sold, employees’ equity won’t be worth anything if the company is in liquidation overhang and the sale doesn’t exceed that amount.*
confusion The complexities of the liquidation preference are infamous. It’s worth understanding that investors and entrepreneurs negotiate a lot of the details around preferences, including:
The multiple, a number designating how many times the investor must be paid back before common shareholders receive proceeds. (Often the multiple is 1X, but it can be 2X or higher.)
Whether preferred stock is participating, meaning investors get their money back and also participate in proceeds from common stock.
Whether there is a cap, which limits the payout if it is participating.
technical This primer by Charles Yu gives a concise overview. Founders and companies are affected significantly and in subtle ways by these considerations. For example, as lawyer José Ancer points out, common and preferred stockholders are typically quite different and their incentives sometimes diverge.
The Holloway Guide to Raising Venture Capital explains liquidation preference overhang in detail.
important For the purposes of an employee who holds common stock, the most important thing to understand about preferences is that they’re not likely to matter if a company does well in the long term. In that case, every stockholder has valuable stock they can eventually sell. But if a company fails or exits for less than investors had hoped, the preferred stockholders are generally first in line to be paid back. Depending on how favorable the terms are for the investor, if the company exits at a low or modest valuation, it’s likely that common shareholders will receive little—or nothing at all.