LP Corner: Understanding the “Equity” of Private Equity (or, An Introduction to Common Stock and Preferred Stock)

​Private equity, generally speaking, is an equity (stock) investment in a privately-held company.  My blog post “LP Corner: What is Private Equity?” provides an overview of how the term “private equity” is used.  This post is going to explore the “equity” component of “Private Equity.”  This post is a complement to my posts "LP Corner: What is Private Equity" and "LP Corner: The "Private" in Private Equity".
 
Let’s start with a basic definition of equity: Equity is the most basic form of ownership in a company.  Since virtually all private equity-backed companies in the United States are corporations, we are going to focus on equity in a corporation.

​For those unfamiliar with corporations, corporations are entities that are created by filing charter documents with a state, which documents are known as “articles of incorporation” (this term is used in California) or a “certificate of incorporation” (this term is used in Delaware).  Most private equity, venture capital and growth equity-backed companies are formed as Delaware corporations (the reasons for this are legal and are beyond the scope of this post).
 
We said that equity is the most basic form of ownership in a corporation.  This equity ownership is evidenced by stock.  When we say “Private Equity” we are talking about stock ownership in a company.
 
Common Stock and Preferred Stock
Common Stock.  The most basic form of stock is known in the US as “common stock” (in the United Kingdom, this is known as “ordinary shares”).  A share of common stock has some basic characteristics:

• Ownership.  The share of common stock evidences ownership in a company.  As a basic example, if a company has issued 100 shares of common stock to various people, and you own one share, you own 1% of the company.
• Voting.  The holder of that share has the right to vote that share for certain actions, but the primary one is to elect directors.  Most corporations hold an annual shareholder (aka stockholder) meeting, where the shareholders vote for the election of directors.
• Dividends.  A “dividend” is the payment of excess cash by a company to its shareholders.  If the company pays dividends, the stockholders have the right to receive the dividends.  Note that most private companies don’t pay dividends to stockholders, instead using any excess cash to reinvest in the company.
• Limited Liability.  One important characteristic of corporations is limited liability to its shareholders.  This means that a stockholder cannot be held liable for the debts of a corporation.  For example, if a company is sued for $1 billion and it can’t pay the judgment, the shareholders won’t be held liable for the company’s debt.  The worst that can happen is the value of the stock purchased can go to zero.

 
When corporations are formed, the founders will receive common stock.  Common stock is also typically issued by a corporation when friends and family invest in the company.  When more professional investors invest in a company, such as venture capital funds and growth equity funds, these investors will want greater rights than the common stockholders, and so will want preferred stock.
 
Preferred Stock.  Preferred stock is also equity ownership in a company (in the UK it’s known as “preference shares”).  It is “preferred” stock because it has rights and privileges greater to than common stock.  Some of the characteristics of preferred stock include:

• Liquidation Preference.  A liquidation preference is a payment priority in the event of a liquidation.  If a company shuts and there is money left over after all creditors are paid, then that money typically goes to the preferred shareholders before it goes to the common shareholders.
• Convertible.  Preferred stock is generally convertible into shares of common stock at the election of the holder of the preferred stock.  What this means is that if there’s a situation where it’s better for the holder to own common stock instead of preferred stock, the holder of preferred stock can convert its shares of preferred stock into common stock.  The most common situation is when there’s a sale or merger of the company.
• Value Anti-Dilution Protection.  If the company sells preferred stock for $1 per share in a financing, and then in a later financing sells preferred stock for $0.50 per share, the value of the first investors’ holdings declines, or in PE parlance, is “diluted.”  The holders of preferred stock may have rights to mitigate the impact of these dilutive financings.
• Priority Voting.  Holders of preferred stock may have the right to elect a certain number of directors to the board.  For example, if a company has five directors, the preferred stockholders may have the right to elect two of the five directors.  This enables a preferred stockholder to make sure that it is represented on the board of directors.
• Protective Rights.  The company may not take certain actions without the affirmative vote of a majority of the preferred stockholders.  These actions can include issuing more stock, incurring bank debt, merging with or selling out to another company.
• Dividends.  Preferred stockholders may have the right to receive dividends in a stated amount prior to the common stockholders receiving any dividends.  However, as stated earlier, most private companies don’t pay dividends, and so if the preferred stockholders have right to receive a dividend, these dividends aren’t paid out but instead accumulate (and are called “cumulative dividends”) and are only paid out if and when the board of directors vote to pay them, or on certain events, such as on the sale of the company.

 
The rights above are usually found in a company’s articles of incorporation.  There are many other contractual provisions that preferred stockholders will obtain, such as the following:

• Right of First Offer.  A right of first offer provides preferred stockholder to participate in future financings in order to maintain their ownership position.
• Right of First Refusal.  A right of first refusal provides that if an existing stockholder wants to sell its shares, the selling stockholder must first offer the shares to the other stockholders of the company before it can sell to a third party.
• Information Rights.  Preferred stockholders will also want to obtain periodic financial reports (usually quarterly and annually), and have the right to inspect the company’s books and records.
• Registration Rights.  For a stockholder of a private company, it’s not that easy to sell its stock in the company.  First, a buyer must be found.  Second, a price and terms of the sale must be negotiated.  Third, the sale must go through the Right of First Refusal process described above.  Things are very different for companies that are “public,” meaning that the company’s stock is freely sold on a stock exchange such as the New York Stock Exchange or NASDAQ.  For a company to have their stock sold on a public stock exchange, the company must register its shares with the US Securities and Exchange Commission and list their shares with an exchange.  The first time a company registers its shares is known as an “initial public offering.”  Preferred stockholders want certain rights to require the company to list their shares after a period of time, so that they can more easily sell their shares.

 
There are many other rights that preferred stockholders may obtain from a company, but the above lists many of the most common rights and preferences.
 
Also, when a company raises money from professional investors, the preferred stock is given a name, such as “Series A Preferred Stock.”  If more money is raised in the future, the investors in that future series will receive “Series B Preferred Stock,” and so on.  This is because the future investors may want rights that are greater than those issued to the prior preferred stockholders.
 
Note that the above discussion is very general, as there are many complexities and nuances of common and preferred stock.  This post is intended to provide a general overview of equity.
 
So that’s the equity part of Private Equity.  In a future post, we’ll explore the “private” part of Private Equity.
 
© 2020 Allen J. Latta. All rights reserved. ​