Common Stock: Definition, Rights & Valuation in Startups

KEY TAKEAWAYS

• Common stock represents basic ownership in a corporation, typically carrying voting rights and residual claims on company assets.
• In startups, common stock is primarily issued to founders and employees, while investors usually receive preferred stock with additional protections.
• Common shares are valued lower than preferred shares in startups, often at a 20-50% discount through 409A valuations.
• Common stockholders have limited rights compared to preferred stockholders, particularly during liquidation events.
• Understanding common stock is essential for founders when structuring ownership and creating employee stock option plans.

What Is Common Stock?

Common stock represents the most fundamental form of ownership in a corporation. When you own common stock in a company, you possess a fraction of that business, making you a partial owner or shareholder. Common stock is the primary security that corporations issue to raise capital and distribute ownership rights.

In the startup ecosystem, common stock plays a pivotal role in the company's capital structure. Founders typically receive common stock when forming the company, and employees are often granted common stock options as part of their compensation packages. While venture capitalists and other investors usually receive preferred stock with special rights and protections, common stock remains the baseline equity that represents basic ownership in the startup.

Common stock comes with certain standard rights, including:

• Voting rights at shareholder meetings on matters such as board elections, mergers, or major corporate changes
• Dividend entitlements when the company distributes profits (though not guaranteed)
• Residual claims on company assets if the business liquidates (after creditors and preferred shareholders)
• Preemptive rights in some cases, allowing existing shareholders to maintain their ownership percentage by purchasing new shares before they're offered to others

The value of common stock fluctuates based on the company's performance and prospects. For public companies, this value is determined by the market through stock exchanges. For private companies, particularly startups, common stock valuation follows different methodologies, which we'll explore later in this article.

How Does Common Stock Differ from Preferred Stock?

Understanding the distinction between common and preferred stock is crucial for founders, employees, and investors. While both represent ownership, they come with significantly different rights and priorities.

Key Differences

Feature	Common Stock	Preferred Stock
Voting Rights	Yes (typically one vote per share)	Limited or none in most cases
Dividends	Not guaranteed, variable	Fixed rate, priority over common stock
Liquidation Preference	Last to receive proceeds	Receives proceeds before common stock
Conversion Rights	Cannot convert to preferred	Can often convert to common stock
Price Stability	More price volatility	More stable pricing
Recipients	Founders, employees	Investors, VCs
Valuation	Lower (discounted)	Higher

In startups, this distinction becomes especially significant. Venture capitalists and professional investors almost always receive preferred stock, which comes with protective provisions like liquidation preferences, anti-dilution protections, and sometimes dividend rights. These provisions are designed to reduce the investors' risk compared to common stockholders.

For example, if a startup is acquired or liquidated, preferred shareholders might be entitled to receive their entire investment back (or sometimes a multiple of it) before common shareholders receive anything. This means founders and employees holding common stock could end up with little or nothing even in a successful exit if it doesn't exceed the total liquidation preferences.

The discount between common and preferred stock—often called the "common-to-preferred discount"—typically ranges from 20% to 50% in startup valuations, reflecting this difference in rights and protections.

Common Stock in Startups: Founder and Employee Equity

In the startup context, common stock serves as the foundation of the company's ownership structure. Let's examine how common stock is typically allocated among founders and employees.

Founder Equity

When entrepreneurs establish a startup, they generally split the company's initial common stock among the founding team. This distribution should reflect each founder's expected contribution, expertise, and commitment to the venture. Factors that influence founder equity distribution include:

• Idea origination and intellectual property contributions
• Capital contributions by founders
• Full-time versus part-time commitment
• Industry expertise and network access
• Past experience and track record
• Expected future contributions and roles

Rather than issuing all shares immediately, founders typically implement vesting schedules (usually over four years with a one-year cliff) to ensure long-term commitment. This protects the company and co-founders if someone leaves early.

Employee Shares

Beyond the founding team, common stock plays a critical role in attracting and retaining talent through employee stock option plans (ESOPs) or restricted stock units (RSUs). These instruments give employees the right to acquire common stock at a predetermined price, allowing them to share in the company's success.

Key considerations for employee equity include:

• Option pools: Startups typically set aside 10-20% of their equity for future employees, with allocations based on role, seniority, and market standards.
• Vesting schedules: Similar to founder equity, employee options typically vest over four years with a one-year cliff.
• Exercise windows: The period during which departing employees can purchase their vested options (traditionally 90 days, though some companies now offer extended windows).
• Tax implications: Different equity instruments have significant tax consequences for employees, particularly regarding ordinary income versus capital gains treatment.

As a company matures and undergoes multiple funding rounds, common stock typically experiences significant dilution. This makes understanding the pro-forma capitalization table and potential future dilution essential for both founders and employees when evaluating their equity.

Common Stock Valuation: The 409A Process

Valuing common stock in private companies, particularly startups, is a complex process that differs significantly from public market valuations. The most important framework for this process is the 409A valuation, named after the section of the Internal Revenue Code that governs deferred compensation.

What Is a 409A Valuation?

A 409A valuation is an independent assessment of a private company's common stock fair market value (FMV). This valuation establishes the strike price for stock options granted to employees and other service providers. The IRS requires companies to set this price at or above the FMV to avoid tax penalties.

The valuation must be:

• Performed by qualified independent appraisers
• Updated at least annually or after material events (funding rounds, significant business changes)
• Based on reasonable application of recognized valuation methodologies

Common Valuation Methodologies

Appraisers typically employ one or more of these approaches when conducting a 409A valuation:

1. Market Approach: Compares the company to similar publicly traded companies or recent transactions involving comparable private companies, adjusted for differences in size, growth, and risk factors.

2. Income Approach: Estimates the present value of expected future cash flows, typically using a discounted cash flow (DCF) analysis. This requires projecting future revenues, expenses, and cash flows, then discounting them back to present value using an appropriate discount rate.

3. Asset Approach: Calculates the net asset value by subtracting liabilities from assets. This approach is less common for startups with significant intangible value but might be used for asset-heavy businesses.

4. Option Pricing Model (OPM): Treats different classes of equity as call options on the company's future value. This is particularly useful for reflecting the economic rights of different security classes in the capital structure.

5. Probability-Weighted Expected Return Method (PWERM): Considers multiple future scenarios (IPO, acquisition, liquidation, continued operation) and assigns probabilities to each to derive a weighted average value.

The Common-to-Preferred Discount

A critical aspect of 409A valuations is determining the appropriate discount to apply to common stock relative to preferred stock. This discount reflects the superior economic rights of preferred shares, including:

• Liquidation preferences
• Protective provisions
• Dividend rights
• Anti-dilution protections

The discount typically ranges from 20% to 50%, with the specific percentage depending on:

• Stage of development (earlier-stage companies generally have larger discounts)
• Amount of liquidation preference relative to company value
• Probability and timeline of potential exit events
• Volatility of the company's projected value

For early-stage startups with high uncertainty, the discount tends to be larger, while more mature companies approaching an IPO might see the discount narrow as common and preferred stock converge in value.

Common Stock Rights and Corporate Governance

The rights attached to common stock form the foundation of corporate governance and shareholder protection. Understanding these rights is essential for founders when structuring their companies and for employees evaluating equity compensation.

Voting Rights and Control

Voting rights represent one of the most significant features of common stock. Typically, each common share entitles the holder to one vote on matters requiring shareholder approval, including:

• Election and removal of board directors
• Amendments to corporate charter documents
• Major corporate transactions (mergers, acquisitions, asset sales)
• Authorization of additional shares
• Dissolution or winding-up of the company

In startups, founders often establish dual-class or multi-class stock structures to maintain control even after significant dilution. For example, Class A common shares might carry one vote per share, while Class B shares (held by founders) might carry 10 or more votes per share. Companies like Meta (formerly Facebook), Google, and Snap have used this approach to preserve founder control despite significant public ownership.

Dividend Entitlements

Common stockholders have rights to dividend distributions when declared by the board of directors. However, these rights have important limitations:

• Dividends are not guaranteed and only paid when declared by the board
• Preferred stockholders typically receive dividends before common stockholders
• Many startups reinvest profits rather than distributing dividends, focusing on growth

While rare in early-stage startups, dividend policies become more relevant as companies mature and generate consistent profits.

Information Rights

Common stockholders have certain rights to company information, though these vary by jurisdiction and company stage:

• Public companies must disclose comprehensive financial information through SEC filings
• Private company stockholders typically have more limited information rights
• Major stockholders may negotiate enhanced information rights, including financial statements and operating metrics

Employees with small equity stakes often have minimal information rights beyond what the company voluntarily discloses, which can create challenges in valuing their holdings.

Shareholder Agreements and Restrictions

Common stock in private companies typically comes with significant transfer restrictions and obligations outlined in shareholder agreements:

• Right of first refusal (ROFR): The company or existing shareholders have the first opportunity to purchase shares before they can be sold to third parties
• Co-sale rights: Allow shareholders to participate in sales by other stockholders, particularly founders
• Drag-along rights: Enable a majority of shareholders to force minority shareholders to join in a sale
• Lock-up provisions: Restrict share sales for a period following an IPO

These provisions help companies maintain control over their cap table and prevent unwanted third parties from becoming shareholders.

Common Stock vs. Other Startup Equity Instruments

The startup equity landscape encompasses various instruments beyond just common and preferred stock. Understanding how common stock compares to these alternatives provides context for evaluating equity compensation packages.

Stock Options vs. Direct Common Stock Grants

Stock options represent the right to purchase common stock at a predetermined price (the strike price), while direct grants immediately confer ownership.

Feature	Stock Options	Direct Common Stock Grants
Timing of Taxation	At exercise (ISOs may defer until sale)	At grant (unless 83(b) election filed)
Cash Required	Yes, to exercise options	No, but taxes due on grant value
Risk Level	Lower (only pay if company succeeds)	Higher (immediate value at risk)
Upside Potential	Unlimited appreciation	Same as options, but from higher base
Tax Treatment	Varies by option type (ISO vs. NSO)	Ordinary income at grant, capital gains on appreciation

Early-stage employees often receive options rather than direct grants due to the tax advantages and delayed cash requirements.

Synthetic Equity: RSUs and SARs

As companies mature, they may shift from options to other equity instruments:

Restricted Stock Units (RSUs): RSUs represent a promise to deliver shares upon vesting, eliminating the need for employees to pay an exercise price. These are typically used by later-stage private companies or public companies.

Stock Appreciation Rights (SARs): SARs provide the economic equivalent of stock option appreciation without actually issuing shares, paying out the difference between the current stock value and the grant price.

These instruments address different liquidity, taxation, and dilution concerns depending on the company's stage and compensation philosophy.

Founder vs. Employee Common Stock

While founders and employees often hold the same class of common stock, the terms and conditions can differ significantly:

• Issuance Price: Founders typically purchase shares at nominal prices ($0.0001-$0.001 per share), while employees receive options at the current 409A valuation
• Vesting Schedules: Both typically use four-year vesting, but founders might have modified terms
• Repurchase Rights: Companies usually have broader repurchase rights for founder shares
• Transfer Restrictions: Founders often face stricter limitations on selling shares

These differences reflect the unique relationship founders have with their companies compared to employees joining later.

Common Shareholder Rights During Exit Events

Exit events—whether through acquisition, IPO, or company liquidation—represent critical moments for common stockholders when the value of their equity is finally realized. However, the outcome for common shareholders can vary dramatically based on the exit terms and preferences in the cap table.

Acquisition Scenarios

In an acquisition, the distribution of proceeds follows a specific waterfall determined by the company's capital structure:

1. Debt holders receive full repayment first
2. Preferred stockholders receive their liquidation preference (often 1-2x their investment)
3. Remaining proceeds are distributed among all stockholders on an as-converted basis

This structure creates several possible scenarios for common stockholders:

• Home run: Exit value far exceeds preferences, resulting in significant returns for everyone
• Mixed outcome: Exit value covers preferences with some remainder for common, resulting in modest returns
• Preferences only: Exit value only covers preferences, leaving nothing for common stockholders
• Partial preferences: Exit doesn't even cover full preferences, resulting in no return for common stock

Understanding this waterfall is critical for evaluating common stock potential value in different exit scenarios.

IPO Implications

During an IPO, preferred stock typically converts to common stock, eliminating liquidation preferences and creating a single class of shareholders. This conversion usually provides several benefits to former common stockholders:

• Elimination of liquidation preferences above common
• Equal footing with former preferred stockholders
• Increased liquidity through public markets

However, common stockholders still face restrictions post-IPO:

• Lock-up periods (typically 180 days) restricting share sales
• Potential market volatility affecting stock value
• Insider trading restrictions for employees and executives

The removal of preferences makes IPOs generally more favorable to common stockholders compared to acquisitions at similar valuations.

Protective Measures for Common Shareholders

To protect common stockholders during exit events, companies may implement several mechanisms:

• Carve-out plans: Allocate a specific portion of exit proceeds to employees regardless of preferences
• Minimum return guarantees: Ensure common stockholders receive at least a specified amount
• Conversion negotiation: Negotiate with preferred stockholders to waive or reduce preferences in certain scenarios

These protections can help align incentives across shareholder classes and ensure that employees with common stock or options maintain motivation toward a successful exit.

Common Stock Valuation in Different Startup Stages

The valuation methodology and typical discount for common stock evolve as startups progress through different stages of development.

Early-Stage (Pre-Seed to Seed)

At the earliest stages, common stock valuation features:

• Large discounts (40-60%) from preferred stock value
• Heavy reliance on recent financing rounds as valuation benchmarks
• Significant weight on liquidation preferences
• High implied volatility in option pricing models
• Limited comparable company data

For example, a startup with a $5 million preferred stock valuation might have its common stock valued at only $2-3 million, reflecting the high uncertainty and strong liquidation preferences.

Growth Stage (Series A to Series B)

As companies demonstrate product-market fit and growth:

• Discounts typically moderate to 30-45%
• More reliable financial projections become available
• Comparable company analysis becomes more relevant
• Option pricing models incorporate more stable inputs
• Multiple potential exit scenarios can be more credibly modeled

A company valued at $50 million in its Series B might see its common stock valued at $30-35 million as the risk profile improves and exit horizons become clearer.

Late-Stage (Series C+)

For mature startups approaching potential exit:

• Common-to-preferred discounts narrow to 15-30%
• Income approach (DCF) gains more weight
• Direct market comparables from public companies become more relevant
• IPO becomes a more probable scenario
• Time to potential liquidity shortens

A late-stage company with a $500 million preferred valuation might have its common stock valued at $350-425 million as the gap between preferred and common narrows with proximity to exit.

Special Situations

Certain events can significantly impact common stock valuation:

• Down rounds: When a company raises at a lower valuation, common stock value typically falls more sharply than preferred
• Recapitalizations: Can dramatically alter the capital structure, often to the detriment of common
• Secondary sales: Provide direct market evidence of common stock value
• Strategic investments: May include special terms affecting the relative value of common shares

These situations require special consideration during the valuation process to ensure accurate fair market value determination.

The Bottom Line

Common stock forms the foundation of startup ownership structures, representing the basic equity interest in the company. While it carries fewer protections than preferred stock typically issued to investors, common stock provides fundamental ownership rights, including voting control and participation in the company's upside potential.

For founders and employees, understanding common stock—its valuation, rights, and position in the capital structure—is essential for making informed decisions about equity compensation and ownership. The significant discount applied to common stock relative to preferred shares reflects its junior position in liquidation preferences and fewer protective provisions.

As startups mature from early stages through growth and toward exit, the valuation methods and relative value of common stock evolve. This progression typically sees a narrowing discount to preferred shares as exit scenarios become more certain and liquidation preferences become less significant relative to the company's total value.

When evaluating common stock in startups, consider not just the current valuation but also:

• The full capital structure including all preference layers
• Potential dilution from future financing rounds
• Likely exit scenarios and timeframes
• Tax implications of different equity instruments

By understanding these factors, founders can design more effective equity compensation programs, and employees can better evaluate the potential value of their equity packages.