Most startups issue only common stock. But sometimes a startup will encounter a situation, such as raising capital, where having more than one class of stock is beneficial (or required). When startup companies raise capital through the issuance of stock, they typically issue “preferred stock” to their investors.

Definition of Preferred Stock

Preferred stock is a class of stock that provides certain economic and control rights and protections not given to the holders of a startup’s common stock (the founders usually hold the common stock). Hence this class of stock is “preferred.”

Typical economic rights of preferred stock include a liquidation preference, anti-dilution protection, and conversion rights. Control rights deal with a host of voting issues and electing the board of directors.

Which Investors Receive Preferred Stock?

Preferred stock is most commonly issued when a startup undergoes a large financing, such as one with a venture capital fund. Angel investors and the friends & family round may sometimes receive preferred stock. Keep in mind there is no bright-line rule when it comes to angels and the f&f round.

Other than the Capital Raised, Does the Startup Benefit from the Issuance of Preferred Stock?

It sure does. Since preferred stock comes with economic and control rights and protections, common stock typically gets a lower valuation for the purposes of stock option grants or share issuances to the corporation’s employees. Employees can generally exercise their common stock options at a lower price than the price of the preferred stock. Thus, employees may feel as though they are receiving some sweat equity for their contribution to the corporation.

If your startup company launches with more than one founder and your startup plans to eventually be acquired or seek venture funding, your startup’s founders stock should vest over time according to a vesting schedule.

Founding teams might not stay together. And having a missing founder or two with a nice chunk of your startup’s common stock is not a scenario your startup wants when it comes time for an acquisition or venture capital financing.

So instead of the founders getting all their shares of common stock on Day 1, the founders get their stock according to a vesting schedule. The standard vesting schedule for startup companies is four years with a one year cliff and monthly vesting thereafter until the founders reach 100%. The one year cliff means that the founders do not get vested with regards to any common stock until the startup’s first anniversary. Thereafter, the founders get vested every month at an amount equal to 1/48th of the their total common stock.

If a founder leaves before the startup’s first anniversary, the founder leaves without any common stock. If a founder leaves after 15 months, the founder will have 31.25% of his common stock vested (25% after the first year, plus the 2.083% vesting each month for 3 months). Thus, the missing founder leaves the startup with much less shares than if the founders stock had vested immediately. This makes it easier to get the necessary approval (and other issues) to go forward with an acquisition or venture capital financing.