For Startup and Small Business Owners
Common equity is an ownership stake that gets paid after creditors and any preferred equity claims. Founders usually hold it. Employees may receive it through stock grants or by exercising stock options.
The catch: owning 20% of a company does not always mean getting 20% of its sale price. Debt, deal costs, and investor rights can shrink the amount left for common owners.
What Common Equity Gives You
Common equity gives you a share of the value left after higher-priority claims are paid. That is why it is called a residual claim. There is no fixed return or guaranteed payout.
In a company with only one class of stock, common owners generally share the available proceeds based on their ownership. When preferred equity enters the picture, the payout can change.
Common stock often comes with voting rights, but ownership and control are not the same thing. Share classes, board seats, and investor approval rights all matter.
Who Holds Common Equity?
Founders, employees, advisors, and other early team members often hold common equity. Outside investors can hold it, too. Preferred equity is common in venture-backed funding rounds, but it is not a rule for every small business investment.
A stock option is a right to buy shares at a set price. It is not the share itself. An employee generally becomes a stockholder when they exercise the option and receive shares. Restricted stock is actual stock, though vesting and other limits may apply.
For the broader funding picture, see Small Business Equity.
How Common Equity Works
In a Corporation
Common stock represents ownership in the corporation. One share, one vote is a common setup, but some shares carry extra votes or no votes.
Dividends are not guaranteed. Any preferred dividend rights depend on the share terms. When a company liquidates, common stockholders stand behind creditors and preferred stockholders. The SEC’s guide to common and preferred stock explains this order.
In a sale, the deal structure and company documents determine how proceeds are split. A liquidation preference often applies to a sale as well as a wind-down.
In an LLC
An LLC uses membership interests or units rather than corporate stock. Its operating agreement sets the rules for voting, distributions, and buyouts.
Some LLCs have one ownership class. Others have preferred units or a payout waterfall, which sets the order in which owners receive money. Common or residual units may receive distributions only after those earlier tiers are met.
Do not assume an LLC ownership percentage equals the same share of every distribution. Read the operating agreement.
Common Equity Payout Example
Assume investors put in $5 million for preferred equity with a 1x non-participating liquidation preference. They own 25% if their preferred shares convert to common. Existing common holders own the other 75%.
The investors choose either their preference or the payout from converting to common. They do not get both.
The amounts below are proceeds available to equity holders after debt, deal costs, and other senior claims. Assume one preferred class, no accrued preferred dividends, and no other payout adjustments.
| Proceeds for equity holders | Preferred holders receive | Common holders receive |
|---|---|---|
| $4 million | $4 million | $0 |
| $8 million | $5 million | $3 million |
| $40 million | $10 million (convert) | $30 million |
At $8 million, common holders receive $3 million, or 37.5% of the available proceeds, despite owning 75% on an as-converted basis.
At $40 million, preferred holders convert because 25% is worth $10 million. Common holders split the other $30 million. Under these assumptions, the conversion break-even point is $20 million.
For participation rights and other terms that change the math, see Preferred Equity and Who Gets Paid First.
Benefits and Trade-Offs for Owners
Common equity lets owners share in business growth without promising a fixed payout. It can also give founders and employees a reason to build long-term value.
But common holders absorb losses first. They may get nothing in a weak exit, even if the company sells for millions. And shares in a private company can be hard to sell before an exit.
New shares can dilute your stake. For example, if you own 20 of 100 shares, you own 20%. If the company issues 25 more shares and you buy none, your stake falls to 16%. Your dollar value could still rise if the funding helps the business grow.
What to Check Before You Rely on Your Percentage
- Ownership: Does the percentage include outstanding options, warrants, and shares from converting other securities?
- Payout order: What debt, costs, and preferred claims come ahead of you?
- Control: What votes do your shares carry, and who controls the board or has approval rights?
- Restrictions: Are there vesting rules, repurchase rights, or limits on selling your stake?
Model a low, middle, and high exit before agreeing to new equity terms. The cap table tells you who owns the company. The payout terms tell you who gets the money.
Related Posts: Debt vs. Equity Financing | Small Business Equity Types