From day one, Pillar VC offered to buy common stock in startups.
Article originally appeared in TechCrunch.
Instead of the standard 10-page venture capital term sheet riddled with terms and conditions, our team believed that a far simpler structure where we owned the same security as founders would align interests, increase trust, and hopefully, enhance the performance of our investments.
Five years since launching Pillar, as we finish investing our second fund and begin the deployment of our third, we thought it was a good time to reflect on whether buying common stock instead of preferred stock has in fact offered the benefits that we had hoped for.
How preferred stock can result in misaligning incentives between investors and startups
To remind you there are many terms and conditions in a Preferred term sheet that can misalign investors and founders — for brevity, I’ll highlight just two below. For more, see the Term Sheet Grader).
Preference: Preferred stock has a ‘preference’ which gives the investor the right to choose whether they want to get their money back or take their % of the total proceeds. In downside scenarios, having an investor take their money back may mean that they are taking a far higher % of the proceeds than the founders “thought” they sold.
For example, if an investor buys 25% of a company for $2M in the form of Preferred Stock, their break point on this decision will be $8M (which happens to be the post-money valuation of the round). If the company is sold for less than $8M, the investor would rather take their $2M back. If the company is sold for more than $8M, the investor would choose to take 25% of the total.
The Founder thinks that they sold 25% of their company but that percentage is actually determined by what the company is sold for. Yes, if the company is sold for $8M or more, they sold 25%, but if the company is sold for, say $4M, the investors will choose to take their $2M back — which is 50% of the proceeds. Worse still, if the company is sold for just $2M, investors take all of it.
Anti-dilution: This clause means that if an investor buys shares for $10 and the startup raises money in the future at a price point that is lower than $10, the investor’s share price will be recalculated retroactively to a lower price. How is this done? By issuing the investors more shares — diluting the rest of the ownership pie, especially the founders and employees. The company is not performing well and the investors are made whole at the expense of the Founders. Aligned? Hardly.
When it comes to making money as a seed stage investor, the features of preferred stock have very little positive impact in practice. For big wins — the primary drivers of returns in the VC industry these preferred stock features all wash away as all invested capital is converted to common stock. When a startup underperforms or fails, preferred terms rarely matter because there’s little or no pie to divide anyway.
We chose a different strategy — electing to focus our energy on creating the best possible environment to build big outcomes — and to forget about the ‘cents on the dollar’ we could get back in poorer-performing companies if we had negotiated preferred terms. We traded downside protection for upside enhancement.
Snapshot: Pillar’s Common Stock Investments in Fund 1 and Fund 2
Across our first two funds of $57M and $100M, Pillar has invested in 45 companies. For the rounds we have led, we let the founders choose whether they want us to buy common or preferred. In 11 companies we have purchased common. Petri Bio (Pillar’s bio+tech accelerator) has invested in 11 companies, all of which are common stock. All told, 56 companies of which 22 are common = 38%.
Successes of the Common Stock approach
When we first thought of buying common, deeper trust was our goal. It wasn’t about winning the incremental deal or somehow ‘out marketing’ our competitors. It was a desire to be good and to be aligned. After five years, we are convinced that buying common stock has helped founders see that we are on their side and this has resulted in deeper trust and better, faster decision making.
Still, we recognize that deeper trust might not be a convincing enough benefit for some investors. Perhaps this would — Pillar’s most valuable investments are deals our team did as common.
There are numerous investments we’ve made where either the founders were not interested in VC if it came with the usual ‘trimmings,’ or they chose Pillar, regardless of structure, because of our willingness to buy common demonstrated that we ‘walked the talk’ on alignment.
Learning from Common Stock investments
As with any experiment, there are things we have learned that have surprised us and challenges we’ve had to overcome.
First, we’ve been surprised that some founders choose to have us buy preferred instead of common. This happened a few times in our first two years, but why? Because these founders were talked out of it by other investors (who they wanted to include in the syndicate) or, ironically, by their own legal counsel.
Why would company counsel advise founders to take the “standard deal” rather than something that would clearly be better for them? Mostly because they have no experience with it and fear the unknown.For example, the very quick answer you’ll get from counsel is that having investors buy common will screw up the pricing of their employee stock option plan. If they merely invested a few minutes to understand, they would realize it does not. 409A valuation firms know how to handle option pricing in these situations and it is still a significant discount to what investors paid. We have done this many times with no issue.
A second, and more subtle topic is voting thresholds. As a company matures and new investors are added, there’s often a negotiation among the investors as to what voting threshold is required to approve important corporation actions. This typically is discussed as “2 out of 3” or “3 out of 5” investors but is documented as a carefully calculated %, for example 64% is the number of investor shares required to approve a new financing.
Should our common “investor” shares be included in this calculation, or not? This is not an issue between us and the company — the company typically wants us to be included because they know we are the most likely to be aligned with them. But sometimes it is an issue with the new investors who would prefer to have more control over these decisions. They will try to define thresholds based on preferred holdings.
You can think of it as a variant of whether a new Series B will be senior in preference to the existing Series A. This is a struggle among new and old investors — but the strength of the company (and ability to hold the line) is an important input. If the company is in a strong position, the A and B will be pari passu, if the company is in a weaker position, B will be senior to A.
Finally, while we’ve been prepared to trade downside protection for upside enhancement, we’ve yet to see the downside materialize in a way where our investment in preferred would have been better than an investment in common. That time may come, but thus far, buying common has only had upside for us.