Preferred vs Common Stock: The Real Power Play

The “Type of Security” clause in a term sheet specifies the kind of ownership or financial instrument an investor receives in exchange for their investment.  A specific investment type determines the investor’s rights, preferences, and claims on the company’s assets and future earnings.

Some terminology:
Security: In simple terms, a “security” is a tradable financial asset. It represents ownership in a company (like stocks), a debt owed by a company (like bonds), or rights to acquire these (like options or convertible notes).
Equity: Represents ownership in a company. When you have equity, you own a piece of the company.
Debt: Represents borrowed money that must be repaid, usually with interest, by a certain date.
Convertible: Means the security can be exchanged for another type of security (usually equity) under specific conditions.

Why it matters?
The type of security issued significantly impacts a founder’s ownership, control, and potential returns in various scenarios, especially during liquidity events (like an acquisition or IPO) or future funding rounds.
Different types of securities come with different rights and priorities, which can protect investors but potentially dilute founders or limit their upside if not carefully understood and negotiated.
It determines who gets paid first and how much, which can be critical for founders in a sale or liquidation scenario.

Common Variations
The most common types of securities seen in startups include:
Common Stock:
Definition: This is the most basic form of equity, typically held by founders and employees. Common stockholders have the voting rights and a claim on assets and earnings after preferred stockholders and debt holders.
Variations: Often, common stock held by founders will be subject to a vesting schedule, meaning shares are earned over time. If a founder leaves early, unvested shares return to the company. So, if a founder has shares to be vested for 4 years with a 1-year cliff, it means that if the founder leaves before first year, he gets nothing. After the first year, 25% would be vested and the remaining 75% of the shares would be vested over the remaining 3 years over fixed time intervals.
What to negotiate: Founders should ensure fair vesting schedules and clarity on how unvested shares are handled.
What is “natural” and what can be potentially unfair: It’s natural for founders to hold common stock. It can be unfair if there are excessively long vesting periods or punitive forfeiture clauses (causes a founder to lose some or all of their unvested or even vested equity under certain negative or damaging scenarios).

Preferred Stock:
Definition: This is the most typical form of security issued to venture capital investors. Preferred stock typically has higher payment priority than common stock and often comes with special rights, preferences, and protections. It can usually be converted into common shares.
Variations:
Liquidation Preference: Determines the order and amount investors get paid in a liquidity event (e.g., sale, IPO, liquidation).
Non-Participating Preferred: Investors choose to either receive their liquidation preference (e.g., 1x their investment) OR convert to common stock and receive their pro-rata share of the proceeds, whichever is higher. This is generally more founder-friendly.

For example, an investor puts in $1 million for preferred stock with a 1x non-participating liquidation preference. If the company sells for $5 million, the investor can either take their $1 million back (1x preference) or convert their preferred shares to common shares and get their proportional share of the $5 million. They will choose whichever yields a higher return.

Participating Preferred (Capped/Uncapped): Investors receive their liquidation preference and then also participate pro-rata with common stockholders in the remaining proceeds. A “capped” participation limits the total return an investor can receive. An “uncapped” participation can be detrimental to founders, as investors get both their money back and a share of the rest.
For example, an investor puts in $1 million for preferred stock with a 1x participating preferred liquidation preference. If the company sells for $5 million, the investor first gets their $1 million back. Then, the remaining $4 million is distributed among all common shareholders (including the investor’s converted shares) proportionally. This means the investor effectively gets their money back and a share of the rest.
 
Dividends: Preferred stock may accrue dividends, which can be cumulative (unpaid dividends carry over and must be paid later) or non-cumulative (shareholders do not have the right to claim those unpaid dividends in the future). Non-cumulative is more founder-friendly.
Anti-Dilution Provisions: Protect investors from their equity stake being diluted if future shares are issued at a lower price (a “down round”).
Full Ratchet: More investor-friendly; it fully resets the investor’s conversion price to the lowest price of any subsequent share issuance, significantly increasing their ownership.
Weighted Average (Broad-Based/Narrow-Based): More founder-friendly; it adjusts the conversion price based on a formula that considers the number of shares issued in the down round. Broad-based weighted average is generally better for founders than narrow-based.
What to negotiate: Founders should aim for 1x non-participating liquidation preferences, non-cumulative dividends, and weighted-average anti-dilution (best case scenario).
What is “natural” and what can be potentially unfair: Preferred stock is natural for VC investments. Unfair terms include high liquidation multiples (e.g., 2x or 3x), uncapped participating preferred, and full-ratchet anti-dilution.

Convertible Notes:
Definition: A short-term debt instrument that converts into equity at a later date, usually during a future equity financing round. Until conversion, it acts like a loan with interest.
Variations: Often include a “discount” (investors convert at a lower price than new investors) and a “valuation cap” (a maximum valuation at which the note can convert, protecting early investors if the company’s valuation skyrockets).
Why it matters: Common in seed rounds, as it defers valuation discussions to a later date, simplifying early fundraising.
What to negotiate: Founders should focus on reasonable discounts and caps.
For example, an early-stage founder raises $200,000 via a convertible note with a $5 million valuation cap and a 20% discount. When the company later raises a Series A at a $10 million valuation, the convertible note converts into equity at the capped valuation of $5 million (effectively a price per share based on $5 million, rather than $10 million), or with a 20% discount if the uncapped valuation is lower than the cap.
 
SAFE (Simple Agreement for Future Equity):
Definition: A more recent, simpler instrument than convertible notes. It’s not debt; it’s an agreement that provides rights to future equity without determining a specific price per share at the time of investment.
Variations: Similar to convertible notes, SAFEs often have valuation caps and/or discounts.
Why it matters: Highly favored by early-stage startups due to its simplicity and avoidance of debt characteristics (no interest, no maturity date).
What to negotiate: As with convertible notes, negotiate fair caps and discounts.

Evolv’s Recommendations
Prioritize Understanding: Do not sign anything you don’t fully comprehend. Understand how each security type impacts your ownership, control, and potential payout in different exit scenarios.
Beware of Complexities: While simplicity (like SAFEs) is attractive, even “simple” agreements have nuances. For preferred stock, look into liquidation preferences (aim for 1x non-participating), anti-dilution (aim for weighted average), and dividend rights (aim for non-cumulative).
Valuation Cap vs. Discount: For convertible instruments (notes, SAFEs), understand the interplay of the valuation cap and discount. A low cap can significantly dilute you if the company performs well.
Future Dilution: Always consider how the chosen security type will affect your ownership in future funding rounds. Harsh anti-dilution provisions can severely impact your equity in a down round.
Seek Experienced Legal Counsel: This is very important. An experienced startup lawyer can spot red flags, negotiate favourable terms, and safeguard your interests.
Focus on Alignment: Beyond the numbers, consider if the chosen security type aligns with the investor’s incentives with the long-term success of the company and the founders.
Understanding the “Type of Security” is foundational to navigating term sheets effectively. By grasping these concepts, founders can protect their interests and build a strong partnership with investors.