Preferred stock is a class of shares carrying special rights and protections that investors receive in exchange for funding a startup. The key rights typically include a liquidation preference that gets investors paid first in an exit, anti-dilution protection that adjusts their price in a down round, voting rights over major decisions, board representation, and information rights. Founders and employees hold common stock, while investors hold preferred stock that usually converts to common in an IPO or a strong exit.
When investors put money into a startup, they almost always receive preferred stock rather than common stock. Preferred shares come with protections that common shares do not have, and those protections shape exactly how proceeds get split if the company is ever sold.
The liquidation preference lets investors get paid back before common shareholders in an exit, and anti-dilution protection adjusts their conversion price if a down round occurs later. Preferred shareholders also typically hold voting rights over major decisions such as selling the company, raising more capital, or changing the charter, along with the right to appoint board members and to receive regular financial information from the company.
Founders and employees hold common stock, or options to purchase it, while investors hold preferred. In a strong exit, preferred stock usually converts to common on a roughly one-to-one basis once the common payout would exceed what the liquidation preference guarantees.
In a modest or difficult exit, preferred shareholders get paid first instead of converting, and common shareholders can end up with very little.
Say investors put in $5 million for preferred stock with a standard 1x, non-participating liquidation preference, and the company later sells for $20 million. In that exit, preferred holders can either take their $5 million back first, or convert to common stock and take their pro rata share of the full $20 million, whichever amount is larger, and at that valuation they will almost always choose to convert.
If the same company instead sells for only $6 million, preferred holders take their $5 million off the top rather than converting, leaving just $1 million to split among every common shareholder, founders and employees included.
Founders often underestimate how preferred rights compound across rounds, since each new round adds another layer of preference sitting above common stock. Ignoring participating preferred terms is another costly mistake, since those terms let investors both get their money back and share in whatever proceeds remain.
The exact terms in any term sheet vary deal by deal, so have a startup lawyer review the actual liquidation preference, participation rights, and conversion terms before you sign anything.
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