Finance: What's the Difference Between Common and Preferred Shares?

What is the difference between common and preferred shares? Common stock is at the bottom. It comes at the very end, when a company is sold, in the priority stack. It sits behind bank debt, the IRS, preferred stock, and pretty much everything else. The big advantage of common stock? It is the proletariat of investing: common stock shareholders elect the board of directors, who then are responsible for managing the company from 37,000 feet.

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Transcript

00:29

basically goes bankrupt. that is you know nots on this storm and warm long .well in

00:35

the real world there's preferred common stock in both private companies and

00:39

sometimes in public ones . when private companies preferred is the dominant

00:44

initial investing vehicle. in public companies it's the opposite . why? well

00:49

because little tiny companies with two geeky techie kids in a garage in Palo

00:54

Alto are vastly more risky investment than those done in large public

00:59

companies like in coca-cola or Pepsi. when you buy shares of Apple today

01:04

you're buying common shares. ticker a APL this thing right here .so the priority

01:10

stack of who gets what when goes something like this- any cash left over

01:14

in a company liquidation meaning bankrupt so the auctioneers are just

01:18

selling it on eBay in parts. the first money goes to employees like we wrote a [cash in water]

01:23

paycheck. and then there's vendors and like a plumber an electrician who came

01:27

did work and never got paid for it. and then there's bank debt if there is any

01:32

collective paid next. then secondary loans from more risky than bank lenders

01:38

get paid like if venture debt is out there it's it's below bank debt. then

01:42

preferred shares get paid off in full then finally common shareholders get

01:47

paid if there's any money left over and there usually isn't. now in the hopes

01:51

dreams and whimsy of early-stage company investors called venture capitalists, all

01:56

of their companies do well grow fast and they go public. and usually at the IPO

02:01

all of the shares have preferred convert into one class of share called

02:07

common stock. and that's when things go well . that's what venture capitalist

02:12

dream about everything converts preferred becomes common, one class of [man looks excited as he holds pile of cash]

02:16

stock like a APL .but when things don't go so well it gets ugly.

02:20

well uglier. yeah alright let's walk through an example. big deal.com rates

02:25

four million bucks in venture capital. took out a 1 million dollar bank line of

02:30

credit which it fully drew down meaning actually borrowed a million dollars so

02:34

it's got five million bucks cash to working with and it has 200 grand in

02:38

builds owed to employees and vendors like Amazon Web Services Paddy's party

02:43

planning and Joe's five-second rule catering. the company is then sold as

02:49

scrap to a competitor for seven million dollars. so who gets what? well first the

02:55

employees and vendors get paid two hundred grand right off the top three

02:59

six point eight million left. then the million bucks from the bank credit line

03:03

gets paid. and if there was any BAC interest owed well that'd be in here as

03:07

well so we're down to five point eight million dollars left. then the four

03:12

million dollars of venture capital investment gets paid because it was in [equation]

03:16

preferred shares. that gets paid back to the venture guys who notably get all of

03:20

their money back even though the company did not do well. yeah so you'd ask why do

03:24

venture capital people get such a perk of getting their investment back first

03:28

the head of the common shareholders and the founders of the company? well because the

03:32

venture guys take a lot of risk and because many many many companies can't

03:36

even sell for the seven million dollars in scrap, so the four million that the

03:40

venture capital is put in often is worth well pretty much zero zilch zip. so the

03:45

investors have to be paid for the risk that they're taking when they invest

03:50

otherwise they just wouldn't invest as much and that's bad for everyone. after [investors smile]

03:54

this four million bucks is gone well they're swimming at one point eight

03:57

million dollars left and it's that amount that gets split among all the

04:01

other common shareholders. the founder owns 30% of the common at this point. so

04:07

she keeps five hundred forty grand. and the employees who had stock options and

04:11

other investors while they keep the rest. all kind of split up. in practice the

04:16

details make these transactions way way way more complex and there's lawyer

04:19

involved. sorry some term sheets from venture capitalists required that their

04:24

preferred be paid back twice before any common gets paid. so in this case the

04:29

four million dollars would have had to be eight million dollars paid back to

04:33

the venture guys before anything went to the common shareholders. there we've got [list of who gets paid what]

04:37

nothing right why would a founder take such abuse and what's called a 2x

04:42

liquidation preference? well the answer valuation. that is for a simple 1x or one

04:49

x just give us our money back and we'll move on kind of deal the valuation of

04:55

big deal com might be ten million dollars. but if the founder wants a

04:58

valuation of fifteen million dollars or more to stave off dilution from outside

05:03

investors. well she might give on key terms like liquidation preference

05:08

multiples because before the company's funded she's dreaming she's the next

05:11

Google right? and in the case of big deal commit mattered a lot. here the founder

05:16

leaves with over half a million dollars not bad for a failed company right? but

05:22

if they've negotiated for a higher valuation and the VCS had gotten a 2x [woman walks off with pile of cash]

05:26

liquidation preference well the founder would have left with nothing. the idea

05:32

here is that term sheets are complicated and there's an army of lawyers in

05:36

Silicon Valley who negotiate these things all day long. this all they do. so

05:41

I don't want to negotiate against them. got it ?there you go

05:44

common versus preferred shares. not a fair fight. check they're not even in the

05:49

same weight class. yeah all right moving on [cage fighter jumps up and down]