Common/Ordinary vs. Preference Shares
When you first create your startup you will usually open a company called a “private limited company”. There are variations of this name depending on the jurisdiction. The “limited” part means that liability is limited to the business so the individual shareholders are not directly liable for business dealings. This concept may seem normal to us these days but it was revolutionary when it came to prominence during the Dutch Golden Age.
When you first create your company you will almost always only have just one share class called “common shares”. At this point, usually it’s just the founder(s) who are owners of the business. This is all fine and good.
When you raise early stage capital from investors you should try and get them to invest via a convertible note (CN) or ideally a SAFE. Do not give them shares directly in the business. It’s better for both the company AND the investor.
Why?
CNs/SAFEs are quicker and cheaper to implement and importantly, if there are any mistakes uncovered in the future, it’s easy to create new docs that replace the incorrect docs. This happens more often than you may think.
SAFEs/CNS will usually convert into preference shares when an institutional round is raised. Investors should more or less always prefer preference shares over common shares.
Why?
Preference shares usually offer several advantages over commons shares including:
- In a liquidation they have priority to receive any remaining assets over common shares
- Preference shareholders often get a “liquidation preference” ensuring that they will receive their invested capital back before any amounts are paid to other shareholder classes.
- Preference shares often come with certain rights requiring their permission to do things like sell the company, take out loans, change the leadership team, etc.
The bottom line is that preference shares are better for investors than common shares. If you choose to take common shares now you may be leaving money on the table in the future in addition to having less control over the business.
A number of our startups encounter early investors who want to own shares directly in the business rather than investing through a CN/SAFE. This is short term thinking. Founders should try to convince them to use a CN/SAFE for the benefit of both the investor and the startup.