I’ve been an entrepreneur and venture capitalist since 1994. I’ve seen multiple cycles for our industry — good times followed by bad times followed by good. The firm I worked with for 18 years helped finance over 150 companies, a few dozen in which I was personally involved. The sample size is big enough to spot a few patterns, and having done so I’m left thinking there has to be a better way.
The particular aspect I’m referring to is the structure of investments in early stage companies, aka “Preferred Stock.” For those who don’t live in this world every day, a share of Preferred Stock can have terms and rights “Common Stock” lacks — preference, dividends, board representation, anti-dilution clauses, special voting rights, etc. Preferred Stock has nearly 100% market share when it comes to funding startups, and among the most common preferential terms is one, appropriately called a Preference. Preference means that at the time of an exit, the investor can choose to either take their money back or convert their investment (thus the actual name Convertible Preferred Stock) into a percentage of the company and take the resulting share of proceeds. 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 (calculated as $2M divided by 25%). 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. It’s kind of a one-way bet. If the value goes up, the investor participates in that gain. If it doesn’t they can get their money back — at the expense of the common shareholders — aka, “founders, management and employees”.
What I’ve observed is that this structure can do odd and unpredictable things in misaligning the interests of investors with those of founders and employees. It can even misalign interests between investors, in cases where later stage investors stack preferences on top of those held by early stage investors or where investors have different break points on their decision to convert or not.
Here’s another preferential term…. The “anti-dilution clause.” Anti-dilution means that if Investor X paid $1/share in a company and the company raises money in the future at a price that is lower than $1, investor X’s share price will be re-calculated retroactively to a lower price. This is quite a feature. Can you imagine buying IBM on the NYSE and being made whole if the price goes down in the future? Even in the most “friendly” deal structures, there are a half-dozen “features” that have been added by creative investors or lawyers over the decades, any of which has the potential to misalign motivations between the investors and employees. Preferred, indeed.
Again, I’ll ask the question… does this structure align incentives between investors and founders/employees? One group has their downside covered, in some cases at the expense of the other. The question isn’t whether that’s right or wrong. In the end one of these shareholders is providing capital, and capital demands what it demands. The question is whether this approach aligns the interests of capital and management, to drive the best possible outcome for both.
Here’s the funny thing. When it comes to making money (the primary job of an investor), the features of preferred stock have very little positive impact in the real world. Think about it. In the big winners, the primary drivers of returns in the VC industry, these features all wash away. Everyone converts into common stock. In the inevitable losers, they don’t matter either because there’s little or no pie to divide anyway. Ask anyone who’s been investing in early stage companies for a long time how often these structures have really made a difference in the returns on a given investment — and then how much it really impacted the performance of a portfolio over a decade or longer. Everyone I’ve every asked — peers and colleagues — has reluctantly admitted its less than 1%.
So why do we bother? Why take the risk of mis-aligned incentives when the actual reward is so low? The default answer, of course, is “Because this is the way its always been done.”
But that’s not actually true.
Back in 1946, the first venture capital firm was created, American Research & Development Corporation by George Doriot, often referred to as the “father of venture capitalism”. ARD funded 150 companies including Digital Equipment Corporation and Ionics Incorporated the latter of which was run by my father, Art Goldstein. Through this experience, I had the good fortune of meeting “The General” Doriot early in my life and many other of the early general partners at ARD who went on to found firms such as Greylock, Palmer Partners and Morgan Holland.
I tracked down several of these individuals and I asked them, “has it always been this way?” After a half dozen conversations with investors, bankers and lawyers all of whom were trying to remember details of deals done 50 years ago, I was directed to a book entitled The Ultimate Entrepreneur, by Rifkin and Harrar. Thanks to the Baker Library at the Harvard Business School I was able to find a copy in the underground stacks. Sure enough, it turns out that the initial investment made by ARD in Digital Equipment was $70,000 for 70% of the founding common stock in DEC — which ultimately generated a 700x return on investment.
So it hasn’t always been that way. There was a time when investors purchased securities that were identical to those held by the founders and employees. As a result, incentives were aligned, resulting in teamwork, trust and in the case of DEC, great accomplishment.
Investing will always be about finding exceptional people attacking or creating big markets with a disruptive idea — when we find one, we can invest on terms that align investor, founder and employee interests and focus on upside enhancement, not downside protection. We do that by buying common stock, just the way ARD did in 1957. There is a better way, and now is the time to begin.