ShmoopTube

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finance a la shmoop. what's the difference between common and preferred

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shares? hmm well common versus preferred shares. the Smackdown. who would win well

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in a fight near bankruptcy a financially stressed situation preferred shares win

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hands-down. in the investing landscape there's a stack or priority list for who

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gets paid what when. in the situation where a company is insolvent or [kid smiles and gives thumbs up]

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

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

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

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

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

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

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

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

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

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in a company liquidation meaning bankrupt so the auctioneers are just

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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