Stock holdings are among the most common form of investment vehicles in the world. In the case of public companies, these are often held via mutual funds, or purchased as part of a larger portfolio. The ownership potential of public market shares is held by anyone, but these represent shareholding interests that differ greatly from the venture capital market. In most public companies shares are of the same class.
For entrepreneurs and venture capitalists common stock and preferred shares are materially different. The difference between common and preferred shares can be notable, making a significant impact on the ambitions and end goals for those seeking beneficial investments.
Common V. Preferred Shares: Effect on the Entrepreneur
Common Shares / Common Stock
Common stock, as the name implies, is the most common form of stock a company sells. It is the basic class of share that the company starts with when formed. It is also the standard equity that the entrepreneur owns in the company. Common stock does provide ownership rights in relation to the amount of stock owned, subject to any limitations that have been agreed to in the course of shareholder agreements and financing activities. Like most investments, the value of the common stock appreciates in value as a company grows, sometimes in amounts in excess of any cap placed on preferred shareholders. That said, a cap on the return to a preferred shareholder is rare, but not unheard of.
Common stock tends to come with voting rights. These rights may be proportionate to the entire company, may be limited, or may be worth more than the voting power of other share classes. This is negotiable, and something the entrepreneur needs to consider. In most cases during a funding event, the rights of the common shareholder often become more restricted, or rather, the rights provided to the preferred shareholder become superior. But like everything else, those restrictions are negotiable. Just as the investor will seek to maximize the amount of control they have on their investment, they will appreciate and support the entrepreneur’s efforts to negotiate and win additional rights, IF those wins are tied to company success metrics.
Regardless, it is normal that the investor(s) in a company have significant rights in the decision-making process related to company operations, board elections, and other measures as posed by the board of directors. With each round, new investors will expect to participate on the board of directors. Typically, a first round results in a three person board: the founder / CEO, the investor, and one independent mutually agreed to by all parties.
Many founders believe, wrongly, that they will always be the CEO of their company. As a company grows, founders often end up in different roles within the company. Wise founders plan and prepare for these changes. The best founders actually engineer these changes, bringing new team members on board who each have greater expertise. The best founders are able to focus on what they are exceptional at, and surround themselves with experts in all other areas of the company.
If you are not raising venture capital, then common v preferred shares really is rarely an issue for you. But if you are raising capital you need to have the mindset that as soon as you do raise the capital, it is no longer your business. It’s yours, and your investors. And, it’s also your team’s business. If they have options, they have a vested interest in the business. We will discuss Options, and ESOP’s in a future article.
Preferred Shares
Preferred shares are less common and function a little differently than a standard common stock investment. As implied by the name, preferred shareholders receive preferential rights in certain circumstances outside the bounds of common stock. Primarily, preferred shares have first rights in terms of liquidation; before common stockholders can be paid, all preferred shareholders must first be paid out, essentially securitizing an investment. This initial preference is often expressed as a multiple, like 1x, 2x, or 3x, which indicates the amount that must be repaid prior to payment to common stockholder.
In addition to the benefits provided by preference, preferred stock also carries other advantages for investors. Participating preferred stock, for example, gives investors the right to receive additional dividends based on specific set of conditions above what preferred stockholders receive. Some forms of preferred stock also come with anti-dilution provisions, which prevent against equity dilution when prices drop below invested amounts. This means the common shareholders, and any preferred shareholder without anti-dilution protection will absorb most or all of the dilution. We will get to anti-dilution clauses, and preference multiples in a separate article.
Most book-based education related to preferred shares indicates that preferred stock do not come with voting rights. In private company venture capital funding, this is almost unheard of. Preferred shares are considered to be an entirely different class, with voting permissions and board seat allocations, often in excess of what common shares get allocated. Protective provisions may also provide extra security, allowing investors to veto or block corporate actions.
Shareholder agreements for preferred stock holders frequently come with other protections, such as voting rights agreements and drag-along clauses in case of sale or merger, entrenching shareholders firmly within a company’s executive structure. Although each company is structured differently, preferred shareholders also have guaranteed pro-rata rights to invest in following rounds, increasing ownership percentage and carrying more authority in corporate decision making, an opportunity common shareholders don’t always get.
In general, preferred shares are more likely to receive payout, or a return on capital. Without the unlimited risk that common shares carry, this class of share is the vehicle of investment preferential for venture capitalists and angel investors seeking a return over time.
The Bottom Line
Different forms of corporate investor often have different end goals in their investments, and stock choice is often deeply rooted in this. For example, entrepreneurs are interested in the long-term performance of a company, in addition to maintaining all or most control. Venture capitalists, on the other hand, often prioritize a return on investment and the rights that come with ownership, making the more secure preferred stock choice a distinct advantage.
This article is part of a series on Venture Capital Definitions and Lexicon for the entrepreneur.
The Tech Ecosystem in Wales
The city of Newport is the third biggest city in Wales, and IT represents 6.6% of all enterprises in the city. But it’s position in South Wales next to Cardiff is what makes it of key interest as part of the Welsh Global Tech hub. South Wales is among the five fastest growing digital clusters in the UK, according to Tech City’s 2015 report.
Home to the European Centre of Research and Development, Cardiff is the capital and largest city in Wales and the tenth largest city in the United Kingdom.[3] The metro Cardiff regional district incorporates over a third of the total population of Wales, and is part of the Eurocities network of the largest European cities.
Due to public & private support by organizations such as Alacrity, Wales has experienced significant investment in information and communications technology (ICT) infrastructure in recent years. This sector’s research and development activity is anticipated to be the strongest driver of economic growth in the area.
Newport, where Alacrity’s incubator is located has also transformed in the last few years. With IT companies representing 50% more economic activity than the Welsh average, the number of tech sector enterprises and digital startup ventures have grown by 87% between 2010 and 2013. The growth rate is much higher than the average across the rest of the UK, possibly due to the lower cost of living in Wales compared to the larger urban areas.
As Scott Evans from Bring-it views it Wales’ low costs and supportive business community have made it an appealing base for new startups, allowing these companies to resist an unnecessarily early move to London.
“Staff and office space are cheaper than in cities like London and Manchester,” he says. “Groups like Cardiff Start have been a great help, and I’ve been able to attend talks and seminars that have helped my business.”
Originally an agrarian economy, Wales transformed into an industrial powerhouse with the development of mining and metallurgy and is now entering the post-industrial era in which tech is at the forefront.
The tech sector is estimated to contribute over 600 million pounds annually to the Welsh economy. Tech sector companies have tended to specialize in social media, cyber security, sportech, e-commerce, fintech, telecoms and networking, and app and software development. While still small in comparison to other sectors, the growth numbers and opportunity is huge. That growth opportunity was a contributing factor behind Alacrity’s decision to enter the market.
Welsh Economic Growth Initiatives
Organizations like The Alacrity Foundation, TechHub Swansea, the Welsh Innovation Centre for Enterprise, and the Welsh Government, are actively contributing to the development of the tech sector in the country. Three universities in Cardiff provide a steady stream of talent for companies to employ, and government initiatives, such as the Finance Wales Tech Seed Fund and the Accelerated Growth Programme, also actively support a strengthening industry.
Events such as the Digital Conference, held annually in Newport, help to highlight and expand the prominence of the sector. The Wales Start Up Awards also help shine the spotlight on fledgling innovators and exciting ventures in the region.
What is still lacking in Wales is funding, and access to a stronger global network that supports the desire of more entrepreneurs to stay in the country and develop their businesses. As companies from the region become more prominent, better transportation, and improved access to capital will be required for sectoral growth to continue. We are already seeing initiatives underway relating to next-generation Internet access that are propelling Wales to a global leadership position, and these initiatives will only support continued diversification and growth.
The Alacrity Foundation, UK
Primarily involved with recruiting talented graduates into an entrepreneurship program, The Alacrity Foundation, UK is Europe’s only non-profit technology incubator. Through the 12 month program, graduates get access to practical business training, develop their software skills, and interact with experienced mentors to establish and develop UK-based technology companies with a global outlook.
Based in Newport, but focused on assisting entrepreneurs across all of Wales, and the UK, the UK branch of Alacrity encourages Welsh entrepreneurs to take advantage of a broad global network of connections and partners, to drive growth. Working with industry partners, the Alactrity identifies issues in the market, and helps program participants develop appropriate business solutions. Alumni of the program include WhichLEDLight, Learnium, Enjovia, Persona, EchoSec, and Talkative.