Sep 17, 2021
What are Common Stocks and Preferred Stocks?
Before issuing any shares, founders need to understand what the difference between these two equity instruments are!
Equity represents ownership and control of a person in a company. Managing equity and its optimum use is important to keep yourself from diluting too much.
For founders, it is the main currency to hire employees, attract investors and strategic advisors during the early stages of the company. Raising funds, creating ESOP pool and onboarding advisors, all require you to dilute a certain part of equity in your company.
For investors, equity is the tangible value of the investability quotient of a startup. Most of the early-stage founders don't have sufficient data for their startup valuations. While investing, VCs firms put a certain tangible value to the startup, that becomes its valuation, and in return, founders cede a stake to the investor.
There are two forms of equity: common stock and preferred stock. Common stock is the simplest form of equity. It is owned by founders, and also issued to employees through equity-based programs, such as ESOP, RSU, and sweat equity.
Common stocks come with voting rights. Each common stock gives one voting right to the stockholder. When a company liquidates, common stockholders get their amount only after the preferred stockholders and all other debts of the company have been cleared.
Preferred stocks are given to the investors to minimise their risk due to their higher liquidation preference. Preferred stock shareholders get preference in their claim on the company assets at the time of liquidation and many more special rights.
Preferred stockholders usually don’t get voting rights. However, they do have influence over the major decision in the company that may affect their equity. They also get certain rights which are not offered to common stockholders, such as transfer of shares rights.
At the early-stage of the startup, the founders mainly use equity to acquire resources. Equity can be used to attract talent, raise funds and get strategic partnerships.
Through equity financing, you can raise funds for your startup by giving a certain portion of the ownership to the investors. Investors get preferred stocks in exchange for the capital they invest. As a startup, you need money for various purposes such as hiring, product development, marketing, and expansion into other markets. Most startups require various rounds of funding, so you have to be cautious with the speed of your equity dilution.
As a founder, you would like to preserve equity in your startup. If you dilute too much equity in the early stages of the company, this may become a hurdle in attracting future investors. You could make a pro forma cap table to understand your startup ownership structure at different stages. This will help you in taking the right fundraising decisions. You can use an equity management tool like Qapita to do this efficiently. It keeps your cap table updated and accurate, so that. So, you always have clarity about your ownership structure.
Further, you can use Qapita to perform various scenario analysis, know your equity worth, do financial modelling, understand dilution and compare term sheets. This enables you to be in control of your equity all the time.
Investor Rights: While raising funds, investors seek many rights. It’s important to understand how it affects your captable. Some of the most common investor rights are liquidation preference, anti-dilution, participative rights, transfer of share rights (drag along, tag along, right of first offer (ROFO), right to first refusal (ROFR), founder vesting etc.)
Investors demand those rights to minimize their risks. Take founder vesting, for example. In early stages, investors are mainly betting on the founders and their ideas. So, they want the founders to keep working in the startup.
The distribution of equity among employees takes the form of equity-linked programs like ESOP, RSU, and sweat equity. As a rule of thumb, employees who join early get rewarded with more equity since they take more risk and play an instrumental role in building the foundation of the startup.
Hiring the right talents is very important for the growth of the company and for attracting, motivating and retaining good talent, you have to pay them a competitive salary.
At the early stage of the company when you don’t have enough cash, you can create an ESOP pool and give employees ESOP to compensate for the lower cash-based salaries. Stock options are a great way to reward and align employees' interest with the startup. ESOP gives good returns to the employees when the startup grows.
Recently, 35 non-founder employees from several high-growth startups have now held equity worth more than Rs 100 crore. Harshil Mathur, co-founder and CEO of Razorpay says that "Contrary to the popular belief, employees actually stay longer after initial buybacks and do not sell their holdings in a rush."
Mathur added that "Employees realize that salary hikes are not enough to make a significant impact on their lifestyles and increasingly opt for compensation structures that offer ESOPs."
Related Read: [ESOP terms that every founder and CHRO must be aware of.](https://www.qapitacorp.com/blogs/esop-terms-that-every-founder-and-chro-must-be-aware-of)
Similarly, sweat equity shares, though not used as frequently as ESOPs, are issued by a startup to its employees at a discount or for a consideration other than cash for their extraordinary contribution or technical know-how or expertise in the industry.
A Restricted Stock Unit (RSU) is a type of employee compensation in which employees receive company shares at a future date for a very low price. The RSUs vest after the employee fulfills certain conditions. These conditions could be performance-based, time-based, or a combination of both.
As per Indian law, you cannot give ESOPs or sweat equity shares to advisors as they are not employees or directors of the company. Founders use equity as currency to onboard advisors and do other strategic partnerships.
Advisors are industry experts or niche veterans who help in making better business decisions and prevent you from making costly mistakes. Further, advisors help in introducing products/founders in their network, hiring key employees and in raising funds.
It's crucial for you to understand how much equity you should offer to different advisors and strategic partners depending on their contributions and responsibilities in the company. Usually, advisors are given equity of 0.1 to 0.3% at an early stage. But this varies depending upon the type of advisor, what value they are bringing, amount of time an advisor is going to spend, stage and valuation of the startup.
You should have a thoughtful vesting schedule and defined deliverables for advisors equity, so that you won’t cede all equity in one go. This way, they are aligned to continue providing value to the startup. If it doesn't work out, it will save you from unnecessary dilution.
The key to equity management is handling the art of valuation with the science of dilution. . Valuation is notional and dilution is real, so managing dilution helps you always to make sure you have enough ownership in the company for different stages.
When you raise funds, keep in mind to raise enough to achieve your next milestone without diluting much as there is no right formula or method to derive in the beginning to know how much you should give your ownership of the company. As your company starts growing, you can dilute lesser equity at that stage for a larger amount of capital.
Initially, in the seed and series A round, try not to give a large chunk of your ownership to the investors. Too much dilution at the early stage can signal negatively to future investors. It poses a question of whether you’ve enough skin in the game.
Sanjay Mehta, MD, 100X.VC says, Startup founders are vulnerable in the early-stage and end up doling out large chunks of double digit free/consultants/adviser equity without understanding the importance of the cap table. These equity grants without vesting and without any understanding of the buyback options. Seeing the cap table with heavy dilution drives away venture capital. Compensation by equity is the costliest way of financing your business."
Whenever you raise funds, create an ESOP pool or onboard an advisor, you dilute your ownership. As equity is the main (and sometime only) currency you have at the beginning of the startup, it’s very crucial to manage it properly.
Though giving equity will cause certain dilution, it makes stakeholders invested in the growth of the company as ownership aligns their interest with the startup. While giving equity may feel painless (as it saves cash), remember that equity is limited—and dilution is an irreversible process.
