Common vs Preferred Stock: A Founder’s Practical Guide to Cap Table Basics

The Core Difference Between Common and Preferred Stock for Startups

For many US founders, the first venture capital term sheet is a landmark moment. It is also where the language of equity becomes complex, shifting from simple ownership percentages to specific share classes, liquidation preferences, and anti-dilution rights. Understanding the difference between common and preferred stock for startups is not an academic exercise; it directly impacts your control, your financial outcome, and your ability to raise future rounds. Misunderstanding these terms can leave founders with far less upside than they expected.

This distinction is fundamental to the startup equity structure in the USA, particularly for high-growth companies in SaaS, Biotech, and Deeptech that are incorporated as Delaware C-Corps. Getting this right from the start prevents costly legal clean-up and keeps your fundraising process on track.

See the Cap Table Basics hub for broader guidance.

Why Startups Have Two Classes of Stock

The division between common and preferred stock is standard practice in virtually all venture-backed Delaware C-Corps. The structure exists to balance the interests of two different groups. In essence, it creates one class of stock for the people building the company and another for those funding it. Think of it this way: Common Stock is for the builders, like founders and employees, who invest their time and talent. Preferred Stock is for the investors, who provide the capital. This separation allows the company to grant investors special rights and protections for their cash investment without extending those same complex terms to every employee shareholder.

Common Stock: The Basics of Founder and Employee Equity

Common stock is the default class of equity in a corporation and represents true ownership. When you and your co-founders first form your company, you issue yourselves common stock. This is also the equity that employees receive when they exercise their stock options. It carries basic rights, including the right to vote on certain corporate matters like electing the board of directors.

The defining characteristic of common stock is its place in the payout hierarchy. In a sale or liquidation, common stockholders are paid after everyone else gets paid, including debt holders and preferred stockholders. This position means they assume the most risk but also have unlimited upside potential. A typical Certificate of Incorporation for a startup authorizes 10 to 20 million common shares.

It is important to distinguish between authorized shares, the total number your company is legally allowed to issue, and issued shares, the portion actually granted to individuals. The remaining pool of authorized but unissued shares is what you will use for future employee option pools and subsequent investor rounds.

Preferred Stock: Understanding the Investor's Terms

Investors provide capital, and in exchange for that high-risk investment, they receive preferred stock. This class of equity comes with a bundle of contractual rights designed to protect their investment and influence company direction. The reality for most pre-seed to Series B startups is that these terms are standard. Understanding them is key to a successful negotiation. The difference between common and preferred shares is centered on three main areas.

Liquidation Preference

A Liquidation Preference dictates how investors get their money back first in an exit. The most common and founder-friendly version is '1x Non-Participating'. This means investors can choose to either receive their original investment back (1x their money) or convert their preferred shares into common stock to share in the proceeds pro-rata with everyone else. They simply choose whichever option gives them a higher return.

For example, a SaaS startup raises $2 million from investors. The company is later sold for $12 million. The investors can either take their $2 million back, leaving $10 million for common stockholders, or they can convert to their ownership percentage. If their stake converts to 20%, they would receive $2.4 million (0.20 * $12M). They will choose the higher amount.

Now consider a less successful scenario where the company sells for only $5 million. The investors would take their $2 million back, leaving $3 million for common stockholders. This represents downside protection for their investment.

Anti-Dilution Provisions

Anti-dilution provisions protect investors if the company raises a subsequent funding round at a lower valuation, known as a “down round.” The industry standard is 'Broad-Based Weighted Average' anti-dilution. This formula adjusts the investors' conversion price downward to account for the new, cheaper shares, but it does so in a way that considers all outstanding shares, which softens the impact on founders.

In contrast, 'Full Ratchet' anti-dilution is a harsh and rarely seen term. It would re-price all of the earlier investors' shares to the new, lower price, causing massive dilution to founders and employees by ignoring the size and scope of the down round.

Protective Provisions

Protective Provisions give preferred stockholders veto power over major corporate decisions. These rights ensure investors have a say in actions that could fundamentally alter their investment. Common actions subject to these veto rights include:

• Selling the company or a significant portion of its assets
• Changing the company's charter or bylaws
• Issuing stock that is senior to their own preferred shares
• Taking on significant debt above a pre-agreed threshold (e.g., $250k)

The Cap Table: Your Company's Official Scoreboard

The capitalization table, or cap table, is your company's official scoreboard. It is a detailed ledger of who owns what, from the earliest founders to the latest investors and employees with stock options. The cap table records every security issued, the holder, the number and type of shares, and calculates the fully-diluted ownership for every stakeholder.

Failing to maintain an accurate, investor-ready cap table can stall due diligence. According to a 2021 survey by LTSE, 80% of venture-backed private companies found errors in their cap tables during financing or M&A events. These errors can be costly and time-consuming to fix. While many pre-seed companies manage this in a spreadsheet, complexity grows exponentially after creating an option pool and raising a seed round. This is why companies typically move to dedicated cap table software like Carta or Pulley post-seed. An accurate cap table is not just an administrative task; it’s a critical asset for governance and fundraising.

Key Actions for Founders

Navigating the equity types in Delaware corporations is fundamental for any founder targeting venture capital. For US startups, the breakdown between common and preferred stock is the central organizing principle of your ownership structure. Founders who successfully manage their equity focus on three key disciplines.

1. Understand your corporate charter. Know how many common and preferred shares you have authorized. Misclassifying or improperly authorizing shares can trigger costly legal amendments and delay your financing process.
2. Model your exit scenarios. Do not just focus on the pre-money valuation of a term sheet. Use the liquidation preference and other key terms to calculate what you and your team would actually take home in a modest, good, and great exit. This clarifies the true financial impact of investor terms.
3. Maintain your cap table with diligence. From day one, keep your records accurate. Whether in a spreadsheet or dedicated software, an up-to-date cap table is a non-negotiable requirement for any serious fundraising or M&A conversation. It demonstrates operational competence and makes due diligence smoother.

Frequently Asked Questions

Q: What is the single biggest mistake founders make regarding stock?

A: The most common mistake is focusing solely on valuation while ignoring the terms attached to preferred stock. A high valuation with aggressive liquidation preferences or anti-dilution rights can result in founders and employees receiving significantly less in an exit than they expected. Always model your exit scenarios to understand the real impact.

Q: Why can’t a startup just issue common stock to investors?

A: Investors require preferred stock because it provides downside protection and control rights to safeguard their high-risk capital. Without features like liquidation preferences and protective provisions, investors would have the same risk profile as founders but without the same level of operational control, making the investment far less attractive.

Q: How does the difference between common and preferred stock affect my ownership percentage?

A: Initially, your ownership percentage is straightforward. However, preferred stock terms like anti-dilution rights can change the conversion rate of preferred to common stock, especially after a down round. This can dilute your ownership more than you anticipated. The key is to track your fully-diluted ownership on your cap table.