Why Your 'Safe' Late Stage Investment Might Be the Riskiest

This week we're diving deeper into a critical distinction for SPV investors: owning common stock versus preferred stock.

As SPVs have risen in popularity, so have accessing pre-IPO companies with IPOs on the horizon. It is clear that  many investors don't fully understand the critical differences between owning common stock versus preferred stock within these vehicles—differences that can significantly impact returns depending on how the investment ultimately exits. But regardless of the impact, LPs really should know. 

The Primary Disadvantages of Common Stock versus Preferred

As a common stockholder in a private company (whether through an SPV or direct), you face several key disadvantages compared to preferred stockholders:

1. Liquidation Priority Common stock sits at the bottom of the liquidation waterfall. In an acquisition, bankruptcy, or wind-down, preferred shareholders get paid first according to their liquidation preferences (often 1x or higher multiples of their investment), and common only receives proceeds from what remains. This means you could receive nothing even if the company sells for a meaningful amount. This preference becomes critical in downside scenarios. While it typically doesn't matter during an IPO (since preferred converts to common), it provides crucial protection in poor M&A exits where liquidation preferences, debt obligations, and transaction fees often leave common shareholders with nothing.

2. Dividend Rights Preferred shareholders typically receive cumulative dividends before any distributions to common shareholders. While most venture-backed companies don't pay regular dividends, these dividend rights still matter at exit—any accrued dividends must be paid out before common shareholders see any returns, further reducing your potential proceeds.

3. Anti-Dilution Protection Preferred shares often include anti-dilution provisions that protect against dilution during down rounds—when new shares are issued at lower valuations than previous rounds. However, secondary markets typically do not receive these anti-dilution rights, even when buying preferred shares. Common shareholders also lack this protection and bear the full impact of dilution in these scenarios.

4. Conversion Timing While preferred shares can convert to common stock, they'll only do so when it's advantageous to them. This optionality means preferred shareholders capture upside while having downside protection that common shareholders lack.

5. Valuation Disconnect The common stock price (409A valuation) is often significantly lower than the preferred stock price, reflecting these structural disadvantages and making your equity worth less on paper. However, this gap tends to narrow for high-performing companies approaching an IPO, where the difference between preferred and common price per share becomes less pronounced as conversion becomes more likely.

The core issue is that preferred stock is designed to provide investor protections, and other benefits, that common stock simply doesn't have, leaving common shareholders as the residual claimants with the highest risk and often disproportionately lower returns relative to company value creation.

Why Common Stock is More Prevalent for Individual Investors in Pre-IPO Opportunities

In highly sought-after pre-IPO companies, individual investors accessing opportunities through SPVs typically encounter common stock rather than preferred shares due to several structural factors.

Most SPV opportunities targeting individual investors involve smaller block sizes ($200k to $5m), which align better with employee shareholders selling common stock rather than institutional investors with preferred positions. Large institutional buyers often require $1M+ minimums—sometimes much higher—creating a natural segmentation.

Transfer Restrictions: Preferred shares generally face fewer transfer restrictions and are more likely to receive company approval for secondary transactions. Common shares, while not universally restricted, tend to have more limitations around transfer rights, though this varies significantly by company.

While larger SPVs do execute institutional-sized transactions ($10M to $100M+) that may include preferred shares, these opportunities typically aren't accessible to individual investors due to minimum investment requirements and deal structure.

IPO vs M&A Exits Have Different Implications

The choice between common and preferred stock becomes most apparent when examining how these securities perform in different exit scenarios.

Initial Public Offering (IPO) Scenarios

In IPO scenarios, the differences between common and preferred stock largely disappear.

1. Automatic Conversion: Preferred shares convert to common stock upon IPO, assuming certain conditions are met (typically a minimum valuation threshold). This means all shareholders end up owning the same security type post-IPO, regardless of their original share class.

2. Elimination of Preferences: Once converted, liquidation preferences and other preferred stock protections no longer apply. All shareholders participate proportionally in the upside.

Merger & Acquisition (M&A) Scenarios

M&A exits reveal the true power of preferred stock structures:

Liquidation Preferences in Action: Preferred shareholders get paid their liquidation preference (usually 1x their investment) before common shareholders receive anything. In scenarios where the exit value is modest, this can mean the difference between getting your money back and losing everything.

Participation Rights: Some preferred shares include "participation" rights, allowing holders to receive their liquidation preference AND participate in the remaining proceeds alongside common shareholders. However, participating preferred structures are relatively rare in today's venture market, as they're generally viewed as founder-unfriendly and are typically only seen in distressed situations or highly unusual circumstances.

Example Scenario:

• Company Y sells for $500 million

• Preferred shareholders invested $300 million total with 1x liquidation preferences

• Preferred shareholders receive their $300 million first

• Remaining $200 million is distributed among all shareholders based on ownership percentages

• Common shareholders only participate in the $200 million distribution

Real-World Implications for SPV Investors

When Common Stock May Make Sense

• High-growth companies with strong IPO potential where conversion eliminates preferred stock advantages

• Limited access when common stock is the only available avenue to invest in a specific company

• Valuation arbitrage when you believe common stock is unfairly discounted relative to preferred shares and there's value in that gap

When Preferred Stock Makes Sense

• Earlier-stage or riskier investments where downside protection is crucial given higher execution risk

• Distressed situations where liquidation preferences provide critical protection in potential fire-sale scenarios

• Over-capitalized companies where the liquidation preference stack could exceed the company's realistic exit value

• Complex capital structures where understanding your position in the liquidation waterfall is essential to avoid getting wiped out

• Down-round scenarios where anti-dilution protection (if available) could preserve value

• Conservative exit expectations when you're less confident about achieving a high-multiple outcome and want structural protection

For me personally, I always prefer to buy preferred shares if available. The exception is if there’s real valuation arbitrage in owning common (e..g near certainty of IPO in high performing business, but I can buy common at a discount). 

Remember that the SPV Manager has control: As an SPV investor, you don't exercise voting rights or board seats directly. The SPV manager acts on behalf of all investors, which can dilute some of the governance benefits of preferred stock.

As a final thought, one of the biggest mistakes LPs make is treating preferred and common stock as equivalent investments. They see the same company name and assume similar risk-return profiles, but the reality is these are fundamentally different securities with vastly different downside protection. A $100K investment in preferred shares is not the same as a $100K investment in common shares of the same company—even if both give you exposure to the same underlying business.

Understanding this distinction isn't about avoiding common shares —it's about pricing risk appropriately and making informed decisions about what you're actually buying.

If you enjoyed this article, feel free to view our prior posts on adjacent topics 

• How We Closed 14 SPVs in One Month

• Are VCs the New Bankers

• VC Scouts: Why Waiting for Lead Investors Maximizes Syndicate Success

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✍️ Written by Zachary and Alex