Prefer to Participate

Companies and investors toss around the term “series A round” as though it has a specific meaning that everyone knows. For example, the venerable source Wikipedia states with confidence, “A series A round is the name typically given to a company’s first significant round of venture capital financing. The name refers to the class of preferred stock sold to investors in exchange for their investment. It is usually the first series of stock after the common stock and common stock options issued to company founders, employees, friends and family and angel investors.”

In fact, in the scramble for scarce capital resources that characterizes nearly every early-stage company’s financing, the sequence, process, sources and terms are much more disorganized. This is the wild-west of true capitalism.  Nearly everything goes, and the biggest and fastest guns call the shots. The “guns” are, of course, the dollars sitting in the pocket of potential investors.

The range of issues to negotiate in the capital raising process are nearly endless, so we bite off only a few here. By the way, while we speak here in terms of “stock” issued by a corporation, the same principles apply for “units” of membership interests issued by a limited liability company, which is often the entity form used in the earliest stages. The economic issues are essentially the same, although the partnership tax structure can get quite complex with limited liability company membership units.

The earliest equity funded transaction, after the founders have exhausted their own resources, and whether it comes from “friends and family” (a misnomer to be discussed another time) or so-called angel investors, is frequently structured as a common stock investment. This means the investors have no kind of liquidation preference or preferred rate of return for their investment as compared to the founders. All a common shareholder really gets is one-vote-per-share in any stockholder decisions, inspection rights and a few other rights that rarely come into play, and the right to share pro-rata in any financial return only from the leftovers after creditors and any subsequent investors first take their piece of the money pie.  As hard as it may be to imagine, the first-in investors, who take the highest possible investment risk with their funds, often settle for common stock.  The first rule of capitalism is that higher risk leads to the opportunity for higher reward.  But common stock for early investors turns this rule upside down. Any early investor really should try to negotiate a better deal.

The better deal is what the venture investor will almost always demand—that means preferred stock instead of common stock.  Preferred stock in its most basic terms means that the investor gets paid a preferred return on their investment before the common stockholders get paid anything. If the company pays a dividend, then it goes first to preferred stock. If the company has an exit transaction and liquidates, then again the preferred stockholders get their money first.  The real negotiation comes not over who gets paid first, but how large the first payment will be before the common stockholders get anything.  This is when the investor guns come out strong.

The two basic preferred stock approaches are “convertible” preferred, or “participating” preferred.  Convertible preferred stock essentially means the investor gets a “best of two worlds” deal—i.e. whenever it’s time to pay out money to stockholders, then the investor gets to choose:  either the investor gets a priority payment of the amount invested plus a stated rate of return, or the investor converts into common stock to share pro rata with all other common stockholders based on the number of shares owned. The former is better if the exit transaction is small; the later is better if the exit transaction is large. The investor can wait to see which one would be best.  Participating preferred stock, on the other hand, is a “have your cake and eat it too” deal—i.e. the investor first gets a priority payment of the amount invested (or sometimes a multiple of that amount), plus a stated rate of return, and then the investor also shares pro rata with all the common stockholders based on the number of shares owned. In short, the investor gets both downside protection and upside participation

From the company’s perspective, the best course is probably to seek a fair deal structure that fairly reflects the first rule of capitalism, involving risk v. reward. It’s smart not to try to cut the deal too thin for the investors, as their capital is the essential fuel to power the company forward. Make it a true success opportunity. Investors really should have good downside protection because the likelihood of any return is nearly always small. On the upside opportunity, matching the investors’ return with the founders’ interests is a good way to align everyone to a common purpose.

From the investor’s perspective, this is when negotiating leverage has maximum exposure. The more urgent the company needs equity funding, the more of the upside the investor can demand.  However, some caution is advisable—if the investor takes too big a piece of the upside money pie, then the founders’ incentives can be undermined, and that only increases the prospective investment risk profile.