Lesson: Incorporating Your Venture with Augie Rakow

Step #8 Stock: Common vs preferred stock

The two basic categories of stock are common stock and preferred stock. Common stock generally does not come with very many special rights, it is just an ownership of a certain chunk of the company.

Preferred stock is like common stock, but with certain additional rights.

The most important one is what we call a liquidation preference, probably the most important. At least it is the most important that's almost always there. Most important, most common. What liquidation preference is, let's say a company has ten million shares, ten million shares of stock, and let's say a company gets acquired for $10 million, that's a dollar per share. Let's say a company only gets acquired for $9 million, and so you are not quite get a dollar per share per each person.

A liquidation preference would say that the shares of stock that have a liquidation preference, so liquidation preference would say instead of dividing up the purchase price, the price the company is getting acquired for, instead of dividing it up pro rata, dividing it evenly so everyone gets the same percentage of the proceeds, a liquidation preference says that these certain stockholders get a certain dollar amount first and then only what's left gets divided by everybody.

So let's say, for example, I invest $10 million in your company and I have a total liquidation preference of $10 million. And you go and sell your company, and let's say I own 50% percent of your company, so I have a liquidation preference on ten million then I own 50% of your company. Let's say you sell your company for 20 million. That 20 million would get divided up evenly across everybody, I would get my ten million, you would get your ten million, 50-50.

But let's say you don't sell it for 20 million, let's say you sell it for 15 million, I have my liquidation preference of ten million, I own 50% of the company, you sell the company for 15 million. The liquidation preference would say that I get my ten million first of the total 15 million total purchase price. I get the ten million first and the remaining five than gets divided between people. So it is a protection for the investor, a guarantee that they get the money back. That's the basic idea.

That's the most important special right that preferred stock has. There are others too. For example, another typical one would be that the company can't change the directors or can't sell more stock without my approval or various things like that.