Common Stock vs. Preferred Stock: Which Is a Better Investment for You?
Stock is one of the most popular types of assets for any investor to buy, whether they’re a hedge fund executive managing billions of dollars’ worth of assets, or a beginner looking to start their own portfolio. But not all stock is created equal!
We’ll explain the key differences between common and preferred stock, the pros and cons of each, and where and how you can purchase them.
But let’s start by answering a few fundamental questions:
What Is Stock?
Simply put, stock (also known as equity) is an asset that represents a share of ownership in a company. Ownership of public and private companies are divided into shares, the individual units of stock.
Shares have individual value based on the overall value of the company. For example, if a company is valued at $1B and there are 100M shares, then each share is worth $10 ($1B divided by 100M = $10).
Investors buy stock in the hopes that the value of that stock increases over time. For example, an investor might purchase 100 shares in the company from the example above for $1,000, giving them a 0.0001% ownership stake.
Over the next few years, the company thrives, growing revenues and improving its business model so much so that it becomes valued at $5B. That equity is now worth $5,000 (0.0001% of $5B), assuming no dilution of issuance of new shares, and the investor must choose whether to sell their stock to cash in the returns or hold the investment in the hope that those returns continue to climb higher.
Why Do Companies Issue Stock?
When a startup is first formed, its founder(s) own 100% of the company. But as time goes on, this ownership will be divided and spread across hundreds, if not thousands, of shareholders, as well as employees who have purchased stock options awarded to them as part of their benefits package.
New investors (like angels, venture capitalists, private equity firms, and others) will provide capital for the company to grow in exchange for an ownership stake, in the form of stock. This exchange is based on the idea that the investors’ capital will help the startup scale the business and so increase in value, thereby making everybody’s stock worth substantially more. Advisers will often be granted stock in exchange for providing their continued expertise via advisory grants.
Over time, as more investors become shareholders (whether in future private funding rounds or on the public market), that company will continue to issue new stock, raising more capital in the process. This process increases the total number of shares to allow for smaller ownership stakes in the business.
When companies issue stock in this manner, they dilute many investors’ ownership stakes. By creating more shares, previous investors now own a smaller percentage of the company. However, the value of their investment can increase even as the percent of the company an investor owns decreases, depending on the type of stock they hold.
Which leads us to:
Common Stock vs. Preferred Stock
As mentioned before, stock represents ownership in a company. What differentiates the types of stock are the rights and benefits associated with each class.
Common stock rests at the bottom of the totem pole when it comes to payout. Common stockholders are the last ones to be paid in an exit and the last to receive assets in the event of bankruptcy (after debtholders and preferred stockholders).
Common stock is, therefore, a riskier investment, as holders are less likely to make a return on their money. They can also have their ownership percentage diluted when the company issues more stock. However, common stock usually comes with voting rights. This gives common stockholders a measure of control over the future of the company, proportional to their share of the overall equity.
Company founders usually have common stock in their business, and employee options are generally common stock as well. It may not have some of the bells and whistles of preferred stock (more on that in a second), but common stock is the bedrock of any company’s cap table and is more widely available to retail investors.
Preferred stock gives its owners a preferred position among a company’s shareholders in the event of liquidation, whether acquisition or bankruptcy. In both cases, assets are distributed to owners of preferred stock before owners of common stock (but still after debtholders). Therefore, preferred stock is less risky, to a degree, than common stock.
Additionally, preferred stock often has a higher dividend rate than common stock, and preferred stockholders have priority to receive dividend payments before common stockholders should the company issue a dividend to shareholders. However, dividends are largely irrelevant for early-stage companies with no profits and are not as much a factor in startup investing.
Preferred stock can also come with protection from dilution with anti-dilution clauses. With an anti-dilution clause, even if a company issues new stock, the percentage of the company that the preferred shareholder owns will not decrease (or will decrease to a more limited extent). However, preferred stock often does not carry the right to vote on corporate issues, and, in some cases, can be purchased back by the company at any time.
Generally, not everyone has access to preferred stock in private investment opportunities. Those deals often go to venture capital firms and angel investors. Investments of preferred stock also can require a higher minimum investment to buy in.
Preferred stock in these instances does come with protections, but deals with common shares are more widely available to the general public.
How to Buy Common Stock
Investors can purchase common stock through public equity exchanges, through private investment opportunities, and on equity crowdfunding platforms.
How to Buy Preferred Stock
While common stock is more widely available, there are still many places to find and purchase preferred stock, particularly on public markets. Investors can purchase preferred shares directly via brokerages, through some private investment opportunities, or can choose to indirectly add preferred stocks to their portfolio by way of investing in exchange-traded funds (ETFs), whose assets comprise preferred shares from a variety of different companies.
When it comes to investing in common or preferred stock, investors should consider the pros and cons of each. While preferred stock can offer protections in future funding rounds, it can also require a higher minimum investment. If you’re not a venture capitalist and are just looking to invest a few hundred or a few thousand dollars, there’s nothing wrong with investing in common stock. After all, it puts you and the founder of the very business in the same exact boat. Both of you hold common stock.
You can find companies offering either common or preferred stock on the StartEngine platform, where dozens of investment opportunities are waiting for you!