Preferred Stock and Common Stock Aren’t The Same

When you get an offer from a tech company it will usually be some combination of cash and stock. Small companies give out stock because it's hard to compete, cash-wise, with bigger companies, and a grant of stock or options offers the chance at a large payday down the road.

Valuing the cash part of an offer is pretty simple. How should you value the stock? Well, one answer is whatever someone's willing to pay you for it.

To that end recruiters will sometimes give you information like, "our last round closed at $4.80 per share, so, if you get X shares per year, your stock compensation is worth $4.80 * X." Sometimes recruiters will send a fancy tables showing the value if the company doubles or 10X's its value.

This is a classic bait and switch. When a company raises a round from, say, Sequoia, Sequoia wires money to the company and gets preferred shares. When you are granted stock options as an employee, you are getting common shares. The differences will vary from company to company, but commonly:

  • Holders of preferred shares get paid out before common shareholders (ie you). Bankruptcy is not intuitive. If you get in a traffic accident, the insurers will usually say something like, the other party is X% at fault, and you were Y% at fault, so this is what you owe. Bankruptcy is not like traffic court. All the rights holders ahead of you will get paid out 100% before you see a cent. If the company is sold or liquidated, the preferred shareholders will likely be paid in full before any holder of common stock sees a dollar. Because of this, preferred shares are more valuable.

  • Preferred shares have different voting rights than common shares. A preferred share might get five or ten (or zero) votes, to one for a common share.

  • Preferred shares may have other downside protection in the event an IPO or sale does not reach a target price.

So preferred shares are worth more than common shares. It is a mistake to look at the preferred share price and multiply by the number of shares and use that as the current value of your common shares. Your shares are worth much less than that.

One reason this happens is that preferred shares are easier to value, because there are regular funding rounds, insider sales. Common stock doesn't trade hands that often before an IPO because stock sales often require board approval. But that doesn't excuse anyone from giving you common shares and pretending they are worth as much as preferred shares.

The recruiters and VC's next trick is to pretend that you shouldn't be concerned about the difference between common and preferred stock, because in an IPO preferred stock is usually converted to common stock. That's true. But this is sort of like saying a home without fire insurance and a home with fire insurance are worth the same as long as they don't burn down. If you have common stock, you don't have fire insurance. And a startup is significantly more likely to fail than a home is to burn down.

If anyone tries to convince you that the difference doesn't matter, ask them if they'd like to swap their preferred shares one-for-one with your common shares.

If you are being recruited and someone tries this on you, please point out the difference and explain that you don't appreciate being condescended to. You should also think less of the company. Every one of your coworkers went through the same process of being lied to about their potential share value.

If you are an employer and you want to do this honestly, quote the most recent share price you have, and then explain that that's the preferred share price, but you are not giving out preferred shares. Explain that recruits should value their shares lower than the preferred share price you quoted - exactly how much is difficult to say, but the preferred share number should be an upper bound on that value. If your common stock is traded, or any of your shareholders are forced to mark their shares to market (Fidelity holds them in a mutual fund, for example), you should disclose that.

(You could also let your employees sell their equity more often, maybe to insiders.)

Liked what you read? I am looking for work.

Leave a Reply

Your email address will not be published. Required fields are marked *

Comments are heavily moderated.