Startup Resources: The Difference Between Common and Preferred Share Classes

By Fernando Berrocal

The difference between common and preferred share classes is an important distinction to know for a startup founder. A stock organization's ownership is represented by its “Shares of Stock”. The shareholders are the people who own the organization's stock and therefore are a part of it. Even though shareholders may have an ownership position in the business, they do not have direct control over it, shareholder approval may even be necessary for some decisions made by the organization's “Board of Directors”. Instead of having direct authority over the business, shareholders have a say in who sits on the board of directors. The organization’s officials are under the jurisdiction of the board of directors.

Share Classes for a Startup

Preferred Share Classes vs. Common Share Classes:  The terms “Preferred Shares”, “Series A”, and “Series Preferred Shares” are frequently used. What do these phrases mean, and how do they relate to board control of a startup? Why do most businesses issue numerous classes of stock? Both common and preferred shares are frequently issued by startups. Preferred stock varies from common stock in that it has certain rights and benefits that ordinary stock doesn’t, including, at a minimum, liquidation and dividend preferences. Founders, workers, and consultants will get common stock, whereas preferred stock is typically reserved for investors.

When a startup incorporates, the articles of incorporation that are presented with state officials to register the new corporate organization normally permit a specified number of common shares. When a startup raises a substantial round of funding, it will submit an updated charter with state regulators to allow a new class of preferred stock that will be reserved for the investors in that round of funding.

The startup will normally designate a further series of shares for an issue from the preferred share pool with each succeeding fundraising round. The series of shares that was established in that round of funding for the startup is commonly referred to as financing. The terms "Series A" and "Series B" derive from the fact that the Series A preferred shares were the first to be offered to investors in the startup, followed by Series B, C, and so on. While the ordinary stock is rarely divided into series, preferred stock is usually always divided into one or more series with each round of financing.

How can a business issue stock? A business cannot generally issue stock unless the board of directors has approved the offering and there are sufficient shares available. If a certain class of stock is being offered, there must be enough shares of that class available for issuance. Finally, if the preferred stock being offered is part of a specified series, there must be sufficient shares of that series available for issuance.

Preferred Share Classes in a Startup

Establish the number of authorized shares specified in the organization's "Certificate of Incorporation" to determine how many shares are available for issue. A corporation can’t issue shares that have not been approved by the board of directors. The number of approved shares for each class or series, as well as the total number of authorized shares across all classes of stock, will be listed on the Certificate of Incorporation if the business's stock is divided into classes and/or series. When forming a business, many entrepreneurs prefer to issue 10 million shares of common stock.

If a startup wants to issue shares but doesn't have enough authorized shares, it must submit an updated certificate of incorporation with the Delaware Secretary of State to increase the number of authorized shares available. The modified charter will raise the number of allowed common shares if a startup needed to issue extra shares to workers and service suppliers. The updated charter would change the number of allowed preferred shares in that class and/or series of stock if a startup wanted to offer more shares of preferred stock to investors.

In a business with a basic capital structure, the certificate of incorporation may only allow one class of stock, which is usually common stock. As they scale up and obtain additional funding for expansion, venture-backed businesses would often issue multiple series of preferred stock to investors. Keep in mind that as a founder, your board of directors must approve all employee share grants and stock option awards before these equity grants may be granted as part of their pay package.

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