By Linqto’s Alan Kerlidou & John Murray
This publication marks the beginning of Linqto’s “Demystifying Private Investing”, a series of informational articles that will provide definitions and use-cases of the common terms employed in the field of private investing.
Preferred and Common Stock
Preferred and Common stock are ownership shares — or ‘equity securities’ — issued by companies. These securities entitle stakeholders to a specific ownership percentage of the company. The primary differences between Preferred and Common stock are voting rights and priority. Holders of Preferred stock have priority when dividends are issued, and will be paid first when the company is sold or liquidated. For example, if a company goes bankrupt, the redistribution of the residual assets owned by shareholders will first be distributed to Preferred shareholders, and the remainder (if any) will go to the Common shareholders.
Preferred stock does not generally allow the holder voting rights for each share owned, while Common shareholders do have such voting rights. For startups, Common stock should be issued to founders, offered upon the exercise of options, or sold at nominal value as incentives to senior executives and key personnel. A company typically should sell Preferred stock to investors, in order to raise capital. This enables more capital to be raised per share, compared to the Common share price. Investors can accept this premium pricing, because of the downside protection in the event of liquidation. Investors may also negotiate a variety of other protective measures, including the terms and circumstances under which Preferred stock may be converted to Common stock.
Companies raise capital by issuing shares or other equities in exchange of investors’ cash or equivalent assets. Successful — or promising — companies frequently need operating funds to sustain and expand their business activities. They typically aim to raise cash at a higher valuation per share than their previous funding from investors. For example, a young company may not be generating enough revenue to expand into new markets, and thus has an immediate need of funding to support that business development. Ideally, the company should raise the new round of capital at a higher price per share than the previous round, relative to its prospective growth. A series of funding rounds, each at increased per-share valuation, is an indication of investor confidence that the company is on a promising growth curve. In some circumstances, perhaps when encountering unexpected business challenges, a company may be forced into raising capital at a lower valuation than the previous round. Such a ‘down round’ can be painful for founders and early investors, since it can cause substantial ownership dilution and can damage the company’s reputation.
The stock price of publicly-traded companies is determined by the stock exchange trading activity. Privately-held companies do not follow the same regulation to price their common stocks. The pricing undergoes the scrutiny of a third party to help determine the fair market value (FMV) of the price per share, which is needed in various situations, for example in the event of a tax-free stock option.
This 409A valuation can be conducted either with a Market, Income or Asset approach. The Market approach consists of comparing the company to its competitors that are already established within the same industry. A valuation multiple is then applied to the company’s existing financials to conclude its enterprise value and price per share.
The Income approach is typically employed for companies that have already generated and scaled their revenues. The third party will use the company’s financial history to estimate its future cash flows, which are then discounted to its present value. The present value, also called discounted cash flows, will be the cornerstone to obtain the price per share of the company.
The Asset approach is probably the least employed method. The enterprise value, or price per share, is assessed by taking in consideration the replacement cost and the appraised value of all assets of the firm. This approach ignores the value of concepts like predictions of potential future growth. It is therefore more suited to companies whose primary business is holding priceable assets like equipment leasing, mining licenses, etc.
Stay tuned for Publication #2 of this series, as we delve into more private investing terms.
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