Common vs Preferred Stock: Startup Guide to Liquidation, Conversion, and Cap Table Waterfalls

Common vs. Preferred Stock: The Core Difference for Startups

When a term sheet lands on your desk, the initial excitement is quickly followed by the dense reality of legal and financial terms. For most founders operating without a CFO, this document can feel like a maze. The most important distinction to understand is the difference between common and preferred stock for startups. The stock you and your early team hold is typically common. The stock your new investors receive is almost always preferred. Grasping the rights attached to each class of stock is the first critical fork in the road, determining who gets paid, when, and how much when you eventually exit.

At its core, the distinction is straightforward. Common stock represents basic ownership in your company. It comes with voting rights but sits at the back of the line for payment in a sale. Preferred stock is ownership plus a bundle of special economic rights and investor protections designed to shield them from risk. Think of it as an airline ticket: common stock is an economy seat, while preferred stock is first class with priority boarding and other perks. These perks, like liquidation preferences and conversion rights, fundamentally alter how exit proceeds are distributed and are central to any venture deal.

Liquidation Preference Explained: Who Gets Paid First at an Exit?

In any sale, merger, or winding down of the company, the first question is always how the money gets divided. A liquidation preference answers this by giving preferred stockholders the right to receive their money back, often with a multiple, before common stockholders receive anything. Think of it as the investor’s insurance policy against a low-value exit. The most common term for this in the US venture market is a 1x non-participating liquidation preference.

Understanding the two main types is crucial for any founder.

Non-Participating Preferred: The Founder-Friendly Standard

This is the most common and generally founder-friendly structure in the US market. When an exit occurs, the investor must choose between two options, whichever yields a higher return:

• 1. Take their money back (their 1x liquidation preference). For example, if they invested $2 million, they get their $2 million back.
• 2. Convert their preferred shares into common stock and receive their pro-rata ownership share of the proceeds. For instance, if they own 20% of the company and the exit value is $20 million, their share would be $4 million.

In this scenario, the investor would choose to convert, as $4 million is greater than their $2 million preference. If the exit was only $5 million, their 20% share would be $1 million, so they would choose to take their $2 million preference instead, leaving just $3 million for common stockholders.

Participating Preferred: The Investor-Favored "Double-Dip"

This is a much rarer and more investor-favored term. Here, the investor gets their money back and their pro-rata share of the remaining proceeds. This is often called “double-dipping.” Using the same $20 million exit example, an investor with full participating preferred would first take their $2 million back. Then, they would also receive 20% of the remaining $18 million ($3.6 million), for a total payout of $5.6 million. This structure significantly reduces the proceeds available to founders and employees.

According to a Fenwick & West survey, full participating preferred stock was present in only 1% of US VC deals in Q4 2023. A hybrid version, called capped participation, is a variant where the total return is capped (e.g., up to 3x the original investment). A scenario we repeatedly see is a founder being surprised by this term in a low exit, where it can wipe out all proceeds for common stockholders.

Conversion Rights: When Preferred Stock Becomes Common

If your company does exceptionally well, an investor's pro-rata share of the exit value will be worth far more than their initial investment. At this point, they will want to convert their preferred stock into common stock to maximize their return. This process is managed through conversion rights, which typically come in two forms.

Optional Conversion

An investor can choose to convert their preferred shares to common stock at any time. They will run the math and exercise this option when their ownership percentage of the company is worth more than their liquidation preference amount. This is the mechanism they use to switch from taking their preference to taking their ownership share in a successful exit, as described in the non-participating preferred example above.

Automatic Conversion

This provision forces preferred stock to convert to common stock automatically when a specific event occurs, aligning all shareholders as one class. The most common trigger is a successful public offering. A Qualified Initial Public Offering (QIPO) is a negotiated trigger for the automatic conversion of preferred stock to common stock. Investors will often push for a high bar to trigger conversion, protecting their preferred rights for as long as possible.

For example, QIPO thresholds are negotiated terms, with example high-bar values being a $500 million valuation and $75 million in proceeds. You can see common QIPO triggers in the NVCA model legal documents. Agreeing to a high threshold without modeling its impact can unexpectedly leave investors with superior voting and economic rights long after the company's value has grown, affecting founder control.

Beyond Payouts: Other Key Investor Protections in Startups

While liquidation and conversion rights are about the money, preferred stock also includes other investor protections that affect founder stock dilution and control. Two of the most important are anti-dilution provisions and protective provisions.

• Anti-Dilution Provisions: These protect investors if the company raises a future round of financing at a lower valuation than the one they invested at (a "down round"). These provisions adjust the conversion price of their preferred stock, effectively giving them more shares to compensate for the dilution.
• Protective Provisions: These are essentially veto rights. They give preferred stockholders the power to block major corporate actions, even if they don't have a majority of the votes. Common examples include blocking a sale of the company, the issuance of stock with more senior rights, or changes to the company's charter.

How to See the Real-World Impact: A 15-Minute Waterfall Analysis

These terms can feel abstract, but their financial impact is concrete. To quickly see what they mean for your actual payout, you need to perform a waterfall analysis. This is not a complex financial model requiring enterprise software; it is a simple exercise you can build in a spreadsheet to show how proceeds flow down to each class of stockholder at various exit prices.

What founders find actually works is mapping out multiple exit scenarios. This exercise reveals the tipping point where an investor is better off converting to common stock rather than taking their liquidation preference. Failing to model these scenarios on your cap table leads to inaccurate valuations and potential misreporting. Your simple waterfall model should have columns for variables like Exit Price, Investor Preference Payout, Remaining for Common, Investor 'As-Converted' Value, Final Investor Payout, and Final Founder/Common Payout.

Running scenarios at different exit values will make the mechanics clear. You will see how at low exits the preference dominates, while at high exits conversion is the obvious choice. This modeling is not just for negotiation; proper cap table modeling is also a requirement for accurate financial reporting under US Generally Accepted Accounting Principles (US GAAP). For companies based in the UK, the parallel standard is often Financial Reporting Standard 102 (FRS 102).

Practical Takeaways for Founders

The reality for most pre-seed to Series B startups is that you must understand these core equity concepts yourself. You cannot afford to outsource this understanding completely to your lawyers. The key takeaways are straightforward.

• Know the Market Standard. In the competitive US venture market, 1x non-participating preferred stock is typical. Anything more, especially full participating preferred, is an outlier that requires serious justification and careful modeling to understand its impact.
• Negotiate Conversion Rights Carefully. The QIPO threshold is not a throwaway term. It dictates when your investors become fully aligned with common stockholders. Lower thresholds are generally better for founders, as they remove the complexity of multiple stock classes sooner after a successful IPO.
• A Waterfall Analysis is Not a 'Nice to Have'. It is the most effective tool for translating term sheet legalese into a clear financial outcome for you and your team. This analysis should be a core part of your fundraising and cap table management diligence.
• Understand Your Industry Context. For founders in R&D-heavy industries like Biotech or Deeptech, this level of financial rigor is essential due to long development cycles and high capital needs. This is not just theory; for US companies, understanding rules like Section 174 on the amortization of research and experimental expenditures is just as crucial for your operational health as understanding stock preferences is for your exit. For deeper guidance, see the hub on legal structures and reporting rules.

Frequently Asked Questions

Q: What is the main difference between common and preferred stock for startups?
A: The main difference is that preferred stock comes with economic and protective rights not available to common stock. The most important is the liquidation preference, which ensures investors get their money back first in an exit. Common stock represents basic ownership and is last in line for payouts.

Q: What does a 1x non-participating liquidation preference mean?
A: It means an investor has the right to receive their original investment amount back (1x) before any other shareholders are paid. They must choose between taking that amount or converting their shares to common stock to receive their ownership percentage of the exit, whichever is greater. They cannot do both.

Q: Why don't venture capitalists just buy common stock?
A: VCs invest in high-risk, high-growth startups and need downside protection. Preferred stock provides this through liquidation preferences, which reduce their risk if the company has a mediocre exit. These preferential rights are the standard compensation for the significant capital risk investors take.

Q: Can preferred stockholders lose money on an investment?
A: Yes. If a company fails and is liquidated for less than the total amount invested by preferred stockholders, they will lose money. The liquidation preference ensures they get paid before common stockholders, but it does not guarantee a return of capital if there are insufficient assets.