Common vs preferred shares: what investors actually buy

Founders and employees hold common stock. Investors buy preferred. The difference is not cosmetic, and it is not really about the name: preferred is common plus a list of contractual rights.

Understanding that list is the difference between reading a term sheet and merely signing one.

What preferred carries

1. Liquidation preference

Paid before common on any sale. Covered in full in part 8 — it is the single largest economic term after price.

2. Anti-dilution protection

If you later issue shares below the price the investor paid, their conversion ratio improves so they end up with more common shares than 1:1. Two flavours, wildly different in severity.

Broad-based weighted average — the market standard:

NCP = OCP × (A + B) ÷ (A + C)

OCP  old conversion price
A    fully diluted shares before the new issuance
B    new money ÷ OCP  (shares the money *would* have bought at the old price)
C    shares actually issued in the down round

Worked: preferred bought at $1.00, 10,000,000 shares outstanding, and the company raises $2,000,000 at $0.50 — so 4,000,000 new shares.

B   = $2,000,000 ÷ $1.00 = 2,000,000
NCP = $1.00 × (10,000,000 + 2,000,000) ÷ (10,000,000 + 4,000,000)
    = $1.00 × 12,000,000 ÷ 14,000,000
    = $0.8571

Conversion ratio becomes 1.00 ÷ 0.8571 = 1.167. Each preferred share now converts into 1.167 common shares instead of one.

Full ratchet — punishing:

NCP = $0.50   →   conversion ratio 2.000

Every preferred share converts into two common. On 2,000,000 preferred shares that is 2,000,000 extra common shares conjured from the founders’ and employees’ ownership, versus 334,000 under weighted average.

Full ratchet is worth fighting hard to remove. It is rare in healthy rounds and it appears precisely when you have least leverage.

3. Protective provisions

Vetoes over specified actions, independent of ownership percentage. Commonly: selling the company, issuing senior or equal stock, changing the authorised share count, altering board size, paying dividends, taking on significant debt.

An investor holding 20% can hold a genuine veto over a sale. That is not a misunderstanding of majority rule — it is a contract you signed.

4. Board rights

A right to appoint one or more directors. Board control is separate from ownership: a founder can hold 60% and still lose a board vote if the seats are split 2-2 with an independent who sides with the investors.

5. Pro rata rights

The right to invest again in later rounds to maintain their percentage. Cheap to grant, and it takes allocation away from whoever you might rather have on the cap table later.

6. Dividends

Usually non-cumulative and rarely paid in venture-backed companies. Where dividends are cumulative, they accrue and are added to the preference at exit — read that clause specifically, because it quietly increases the stack in part 8.

7. Conversion

Preferred converts to common at the holder’s option, and automatically on a qualifying IPO. Conversion is what makes the “or convert” branch of the waterfall possible.

Why this makes your 409A make sense

Investors paid $0.6931 per preferred share in part 3, and the 409A valued common at $0.25. The gap is the value of everything above: preference, anti-dilution, vetoes, board seats.

Which is also the honest answer to the employee question “the investors paid four times my strike price — am I being shortchanged?” No: you are being granted a different, more junior instrument, and it is priced accordingly.

Series A, B, C — usually different classes

Each round typically creates its own class: Series A Preferred, Series B Preferred, and so on, each with its own price, preference and terms, and its own seniority.

By Series C a cap table can carry four classes with four different conversion prices and two different anti-dilution formulas. This is the point at which a spreadsheet stops being adequate and quiet errors start compounding.

What to read, in order

When a term sheet arrives, read in this order: price, liquidation preference (multiple and participation), anti-dilution formula, protective provisions, board composition. The first three are economics; the last two are control, and control is what decides whether you are still running the company at Series C.

Next

Part 10 goes back to the option pool: how to size top-ups at each round, how refresher grants work, and how to track a pool so you do not discover you are out of shares in the middle of a hiring push.