Common stock & how it works for startups

What is common stock and how does it affect startup ownership?

Common stock is a type of security representing a company's share of ownership. Startups often issue common stock to founders, employees, and early investors. While it provides voting rights and capital appreciation opportunities, it can dilute founders’ control as the company raises funds or adds more common stockholders. Understanding how common stock impacts ownership is essential when managing a startup’s growth and equity distribution.

Key rights of common stockholders

As a holder of common stock, you typically enjoy these key rights:

• Voting rights: Most shares of common stock come with the ability to vote on critical corporate policies, such as electing the board of directors, approving mergers, or deciding on stock splits.
• Right to dividends: If the company decides to distribute profits, common stock dividends may be paid, although they are often secondary to preferred stockholders.
• Access to capital gains: Common shareholders can benefit from the capital appreciation of their shares if the stock prices increase, particularly during an IPO (initial public offering) or on the stock market.
• Residual claim in liquidation: In the event of liquidation, holders of common stock have a claim on the company's assets after bondholders, creditors, and preferred shareholders are paid. However, these payouts are usually lower and riskier than those of preferred shares.

Common stock vs. preferred stock

When exploring equity options for your startup or investment, it’s important to understand the differences between common stock and preferred stock. These include:

How can dual-class stock systems benefit startup founders?

A dual-class stock system allows startups to issue two or more classes of common stock with different voting rights. This setup helps founders maintain control over critical decisions by issuing common shares to investors even as they raise capital. Here's how this system can benefit you as a founder:

Retain decision-making power

In a dual-class stock system, you can allocate shares of common stock with superior voting rights to yourself and other key individuals. For example, one class may offer ten votes per share, while another class offers one vote per share. This structure allows you to control major corporate policies like mergers, stock splits, or appointing the board of directors, even if your ownership stake decreases.

Attract capital without sacrificing control

By issuing non-voting or low-voting shares of common stock to investors, you can raise funds to grow your company while keeping decision-making authority. This approach is especially useful during an IPO (initial public offering), where you must increase your valuation and access public markets.

Reduce risks of hostile takeovers

With a dual-class structure, you can minimize the risk of losing control through hostile takeovers. Investors who hold common shares with limited voting rights have less influence over the company’s strategic direction, ensuring you maintain authority over long-term goals.

Balance investor interests and founder control

While investors may have fewer voting privileges, they still benefit from capital appreciation and dividend payments tied to their shares of common stock. This structure creates a balance where investors see financial returns while founders retain their decision-making role.

What are the risks and rewards of issuing common stock for startups?

Issuing common stock can provide startups with the capital needed to grow, but it comes with potential trade-offs like equity dilution and reduced control. Understanding the risks and rewards helps you decide if this type of security aligns with your startup’s goals.

Rewards of issuing common stock

Some benefits of issuing common stock are:

• Access to capital: Issuing shares of common stock allows you to raise funds for scaling operations, developing products, or expanding your team. This is often crucial during an initial public offering (IPO) or private funding rounds.
• Attracting investors: Investors see common shares as an opportunity for capital appreciation and potential dividend payments. This makes it easier to secure financing without taking on liabilities like debt.
• Shared risk: Unlike debt financing, issuing equity securities doesn’t require making fixed payments to lenders. This reduces the immediate financial burden on your balance sheet.
• Market value growth: The market value of your common shares may increase as your business grows, providing you and your investors with capital gains.

Risks of issuing common stock

While issuing common stocks can offer various advantages, it also has some limitations, such as:

• Ownership dilution: Issuing more common shares means reducing your share of ownership, which may dilute your control over decisions. This can also affect your influence over the board of directors and key corporate policies.
• Loss of voting power: New common shareholders gain voting rights, which may lead to conflicting priorities between founders and investors. Introducing non-voting shares can be a way to retain control, but investors don’t always accept this.
• Volatility in stock prices: The stock market can be unpredictable. Your share price may fluctuate based on external factors like interest rates, competition, or investor sentiment, creating financial instability.
• Lower priority in liquidation: In the event of liquidation, common stockholders are last in line to claim the company’s assets. Bondholders, preferred stockholders, and other creditors have priority for payouts.
• Market scrutiny: If you go public on a stock exchange, your valuation and performance will be constantly scrutinized. Negative market sentiment can lead to a decline in your market value.

How do funding terms and common stock affect startup control and exit strategies?

The funding terms you negotiate and the type of stock you issue can significantly affect your control over the company and shape future exit strategies like mergers or an initial public offering (IPO). Understanding these factors helps you align with investor expectations while protecting your long-term interests.

Funding terms to consider

Some funding terms that you should consider are:

• Ownership dilution: Issuing common stock or preferred stock to investors reduces your share of ownership. This dilution can lower your control over decisions made by the board of directors, which plays a key role in setting corporate policies.
• Voting rights: Different classes of common stock and preferred shares may carry varying voting rights. Retaining non-voting shares or creating special voting structures can help you maintain control while meeting investor demands.
• Investor influence: Investors who hold common shares or preferred stock often expect a say in decision-making, especially regarding key issues like valuation, payouts, or liquidation plans. Their involvement may limit your ability to operate independently.

Impact on exit strategies

Now, let’s look at how issuing common stock impacts exit strategies:

• IPO readiness: Issuing equity securities like shares of common stock during funding rounds prepares your company for an IPO. However, public scrutiny of the stock market can lead to volatility in stock prices and pressure to maintain high market value.
• Mergers and acquisitions: Funding terms and stock structures influence your ability to negotiate favorable deals during mergers. Investors may prioritize their capital gains or dividend payments, which could conflict with your goals for the company’s future.
• Event of liquidation: In the event of liquidation, common stockholders receive payouts only after bondholders, preferred stockholders, and other creditors. Setting clear payout structures in your funding terms is crucial to avoid disputes.

Wrap up

As a startup founder, your approach to issuing common stock can be consequential down the road. By carefully considering the balance between raising capital and maintaining control, you can create a structure that aligns with your long-term vision while still attracting the investment needed for growth.

Remember, there's no one-size-fits-all solution. The right approach depends on your goals, industry, and growth trajectory. By understanding the nuances of common stock, dual-class structures, and their implications, you'll be better equipped to make informed decisions that set your startup on the path to success.