Preferred Shares vs Common Shares: Which is Right for my Start-up?

Jul 20

First of all, let’s start with the basics. A share is a unit of ownership in a corporation or financial asset. Owning shares in a company entitles the holder to a proportional amount of the profits of the company in the form of dividends. For a start-up company, shares are sold to the public in order to raise capital for their business. [1]

There are two main types of shares: common shares and preferred shares.

Common Shares

As their name denotes, common shares are the most widely distributed form of share. Common shares are typically distributed the in the early stages of a company when attempting to fundraise. Common shares are accompanied by voting rights, which means that common shareholders have a say in how the company is run through voting on important decisions.

Essentially, holding common shares is the equivalent of owning a small degree of the company. Functionally, each share owned equals one vote, therefore the more shares held by an investor, the more say they have in your company. For the average investor, the main benefits of holding common shares is the ability to derive profit from your company. There are two ways in which this occurs, capital gains and dividends. Capital gains are when an investor sells a share above the initial purchase price and dividends are money distributed at set intervals to a certain class of shareholders.[2], [3], [4]

What are the Pros of Common Shares?

Helpful to raise capital without incurring too much debt.
While this dilutes ownership of the company, a shareholder investment does not need to be repaid which is a benefit over debt funding.
Smart investors have the potential to net large capital gains resulting in increased profit.
For investors, the main risk is the loss of the initial investment.

Preferred Shares

Preferred shares are favoured by investors that invest on the first institutional financing round (Series A) because it gives them some advantages in a variety of situations. When an investor holds preferred shares, their rights change as well as the obligations of the company in a situation of insolvency. The holders of preferred shares typically do not possess voting rights and the shares are less likely to appreciate over time, which means less of an opportunity for netting large capital gains. However, preferred shareholders have a higher claim to dividends than those investors who hold common shares. Additionally, in a situation of insolvency investors who hold preferred shares have priority claim to the company’s assets over holders of common shares, however, they rank lower than bondholders.[5],[6]

What are the Pros of Preferred Shares?

For investors, preferred shares offer an extra layer of protection, if the company becomes insolvent, preferred shareholders have a claim on assets before common shareholders.
If the company cannot make a payment, it must pay the preferred dividends in arrears before they pay their common shareholders.
Stable payouts, ideal for investors who are looking for consistency in their investments.