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How does preferred equity work?

Equity represents ownership in a business. The "preferred" component represents additional rights and privileges investors receive in return for their investment beyond owning a percentage of the business. So, in return for investing in a private business, an investor will receive shares (or units, depending on the type of entity they are investing in) that represent their ownership in the business. These shares will be a part of a "class" of securities that the business has issued. A business may have multiple classes of securities.

Usually, a business that takes on outside investors will have at least 2 classes of securities: common equity and preferred equity. The common equity will be the equity owned by the founders of the business, and possibly additional employees or service providers. The preferred equity will be the equity owned by investors. Since investors are providing capital to the business in order for the business to operate, they receive preferential treatment as it relates to certain activities of the business. Here are a few examples:

Liquidation preference: A liquidation preference represents the order in which proceeds of the business are distributed in the event that the business is sold. Often, preferred equity will come with a "1.0x liquidation preference", meaning investors receive 1.0x their investment back before any other funds are distributed to any other owners of the business (i.e. the common equity holders). In this scenario, investors would receive their money back, and then any additional proceeds would be distributed 'pro rata' (based on the percentage of the business each investor owns).

Information rights: Preferred equity holders are entitled to certain rights in order to gain access to company information.

Pre-emptive rights: Preferred equity holders may be offered this right, which allows them the ability to invest in future rounds of equity that are issued by the company to help avoid dilution pitfalls.

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