Preferred and common equity remain important decisions that directly impact financial and managerial outcomes. Understanding both concepts may help protect your wealth and entrepreneurial vision.

Preferred Equity and Common Equity: What Are They?

Generally, Investors who have a preferred equity stake in a company are provided with a higher claim on assets and earnings compared to common stock.

They often receive fixed dividend payments before any dividends are paid to common shareholders, though dividends are not guaranteed. However, preferred equity still sits below senior debt positions.

Common equity, on the other hand, typically represents the fundamental ownership stake in a company.

Investors who have such a stake have voting rights and a residual claim on the company’s assets and earnings. After all debts and preferred obligations are met, common shareholders are entitled to what’s left.

Important Differences Between Preferred and Common Equity

Pros and Cons of Preferred Equity and Common Equity

Preferred Equity

Pros

• Predictable Income: Preferred equity may offer more stable dividend payments than common equity, though they remain subject to company discretion and not guaranteed.
• Higher Liquidation Priority: If the company liquidates, you may get paid before common shareholders and often receive your returns even when they don’t.
• Lower Volatility: These stocks tend to be less volatile; they’re attractive for conservative investors, though they are still subject to market risks.

Cons

• Limited Voting Rights: Typically, preferred equity investors have limited to no voting power except in special circumstances and within specific stock classes.
• Lower Growth Potential: Preferred equity may exhibit lower volatility compared to common equity, but risks remain.
• Conversion Restrictions: Preferred shares may have conversion restrictions depending on the terms of each preferred stock class. \

Common Equity

Pros

• Voting Rights: Common shareholders usually have voting power and may influence company decisions.
• Growth Potential: Common equity may offer significant capital gains, given that the company finds success in the market, though this is subject to market fluctuations and is not guaranteed
• Variable Dividends: If a company performs well, dividends may be increased and provide an additional return component.

Cons

• Higher Risk: Common equity is more sensitive to market fluctuations. During market downturns, you may experience greater losses.
• Liquidation Deprioritization: You only receive payouts after all other obligations are met, including paying preferred shareholders.
• Fluctuating Dividends: Since dividends are variable, they’re never guaranteed and may fluctuate with the company’s performance.

Preferred Equity vs. Common Equity: Options for Investors 

Risk Tolerance and Investment Horizon

Investors prioritizing stability and fixed-income potential may consider preferred equity, while those seeking higher returns with greater risk may look into common equity, based on their investment goals and risk tolerance. Preferred equity typically receives priority in payments, even though dividends may be suspended at the company’s discretion.

On the other hand, if you’re willing to embrace volatility for the chance at higher growth, common equity might be more appealing. It comes with a greater risk, but the potential for significant capital appreciation is there.

Liquidity and Control

Common equity may often be traded more easily since public markets are generally more liquid.

Preferred equity may be traded in public markets, but its liquidity may be less than that of common equity because a smaller group of investors often holds equity shares, and there are usually fewer shares available for trading.

Trading it may sometimes affect the market price. But, generally, it depends on the specific company, the terms of shares, and the market conditions.

Preferred vs. Common: What Founders May Consider

You should be careful to consider the implications about the way you distribute your company’s equity when you’re launching a startup.

Common Equity

Common equity is typically reserved for founders and employees and represents the core ownership of the company.

If your startup performs well, you’ll secure significant upside potential. However, remember that common shareholders are last in line during liquidation events, and dividends are variable or nonexistent until preferred obligations are met.

Preferred Equity

Preferred equity is often offered to external investors, such as angel investors or crowdfunding backers.

They enjoy priority on dividends and liquidation proceeds, meaning they’re better situated in case the company fails and liquidates its assets. Preferred shareholders may have participation rights in a company's growth, depending on the terms of the preferred stock issued.

What to Do as a Startup Founder

Considering the pros and cons of both types, the ideal approach is to strategize your equity distribution.

You may use preferred equity to attract external capital and preserve common equity for the core team to maintain control. Having investors influence major decisions may sometimes complicate matters or dilute the vision that makes your startup unique.

However, there are other approaches to equity distribution, so the best strategy depends on your startup’s circumstances.

Note: Issuing equity requires compliance with SEC regulations, such as Regulation D (for private offerings) or Regulation A+ (for crowdfunding). 

Conclusion

Preferred equity offers stability and predictable income, while common equity provides a greater upside with more influence over company decisions. But most importantly, aligning your equity strategy with your specific goals is the best way to balance risk and reward.

For more professional guidance, check out our resources to learn from decisions that drive startup success!

Disclaimer:  The information provided in this article is for educational and informational purposes only. It does not constitute financial, investment, or legal advice. Readers should conduct their own due diligence and consult with a qualified financial professional before making any investment decisions. Investing in any financial market carries inherent risks, and past performance is not indicative of future results.

This article is published by StartEngine Crowdfunding, Inc., a registered broker-dealer and member FINRA/SIPC. Any discussion of investment structures is presented for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities. Investments in private companies involve significant risk, including the risk of loss.

References

Investopedia - Equity Meaning
Investopedia - Preferred Stock
Investopedia - What Are Convertibles?
Fidelity International - How Shares Work
SoFi - Shareholder Voting Process
NASDAQ - Companies & Unpaid Preferred Dividends

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