[harryh]

Here is where the mistake in your thinking is. In scenario 2 the investor will only agree to put in 1M for a 20% stake if he gets preferred shares. If he only gets common shares he might only put in, say, 500k for 20%.

Assuming that you think the company is going to increase in value, the fact that he has preferred shares won't matter in an exit so you're much better off taking 1M instead of 500k (assuming you can put the extra money to good use). And if you don't think that the company is going to increase in value then why did you start it in the first place?