Post Category → Founders

Common Stock v. Preferred Stock

TL;DR: Beyond the technical differences between Preferred Stock and Common Stock, there are deeper differences in their composition, incentives, and risk exposure that play out in the course of a company’s history. Understanding the tension between those differences is important.

Very quick vocabulary lesson:

Common Stock is the default equity security of a corporation. It’s what founders, employees, advisors, and other service providers get.

Preferred Stock (Series A, Series B, etc.) is “preferred” because it has extra privileges / rights layered on top of it relative to the Common Stock, including a liquidation preference, rights to block certain things, etc. Preferred Stockholders are almost always investors.

Why don’t investors (usually) buy Common Stock? Short answer: why be common when you can be “preferred”?

Longer answer: they want the downside protection that a liquidation preference provides (they get their money back before anyone else), and they want various contractual privileges that separate them from the “common” holders; like the right to elect certain directors. Also, another argument often made is that by having investors buy Preferred Stock, the “strike price” of options (which buy common stock) used as service compensation can be lower (when a valuation occurs). The logic is that common stock at the time is less valuable due to its lower rights and status on the liquidation waterfall.

So if your investors pay $1 for Preferred Stock with a liquidation preference and other rights, you can still issue your employees options at 20 cents per share (or whatever your valuation reflects) without busting tax/equity compensation rules. The options are for Common Stock, which lacks the bells and whistles of Preferred Stock, and therefore the “fair market value” exercise price is lower. If the investors had paid $1 for Common Stock, your employee options would’ve been much more expensive.

Interesting corporate law factoid: between the Common Stock (founders, employees, etc.) and the Preferred Stock (investors), which group does the Board of Directors owe greater fiduciary duties to in the event of a conflict?

Answer: the Common Stock. And yes, that means even the directors elected by preferred stockholders, even if the director is a VC. Ask your corporate lawyer if you don’t believe me. The Delaware case law is pretty clear.  All the more reason to avoid “captive” company counsel, to help the Board actually do its job.

Kind of ironic. The investors get “Preferred” stock, but the Board is actually legally required to “prefer” (in a way) the Common Stock.

Apart from the technical differences between Common Stock and Preferred Stock, it’s important to keep in mind the different characteristics of the people who make up the two groups.

A. Common Stockholders are much less “diversified” than Preferred Stockholders. This is their “one shot.” 

As I wrote in Not Building a Unicorn, venture capitalists and founders/management often have very different incentives when it comes to setting out a growth and exit strategy for a company; especially when the VCs are the type that look for “unicorns” (larger funds).

Most startup investors (preferred stockholders) have a portfolio of investments. If a few go bust, their hope is to more than make up for it with a grand slam from another. For a less diversified common stockholder, like a first time founder: going bust is really going bust.

Imagine, for simplicity, you have 2 potential growth/exit strategies: Option A and Option B. Option A has a 50% chance of success, and would result in the Company exiting at a $80MM valuation. Option B has a 10% chance of success, but would result in a $1B exit.

Now imagine a portfolio of 10 companies, each with an Option A and an Option B. The Preferred Stock are invested in all 10 of those companies, but the Common Stock are exclusive to each company.

Do you think the Common Stock and Preferred Stock are always going to see eye to eye on which option to take? Hell no. With downside protection (liquidation preference) and diversification, preferred stockholders are far more incentivized to take much bigger risks than common stockholders are.

The Common Stock v. Preferred Stock divide is very real, and that matters from a corporate governance perspective.

B. Common Stockholders are typically less “sophisticated,” and don’t have their own lawyers. 

Part of the idea of fiduciary duties is that someone more sophisticated, informed, or influential is given responsibility to look out for the best interests of someone who is less sophisticated, informed, and influential. That’s why the Board of Directors, which has the most power in the corporation, has fiduciary duties to all the smaller stockholders who can’t see everything that’s going on.

Naturally, because many institutional investors are diversified, they are by definition “repeat players,” which makes them more sophisticated at the complexities of financing, corporate governance, etc. In negotiating transactions with the Company (like financings), they also often have their own lawyers to negotiate directly on their behalf.

Common Stockholders rarely involve their own lawyers when they are getting their equity from the Company. They rely much more on the norms of how the Company treats all of its equity recipients. And, frankly, they just have to trust that they will be treated fairly.

It’s worth noting that, at least in this regard, individual angels are a lot more like common stockholders than institutional venture capitalists. They too often sign standardized docs, with little negotiation or personal lawyer involvement, and they also often don’t have visibility into Board decisions. They are usually more trust driven in their dealings with their investments. This is why founders will often feel more “aligned” with angels than with VCs. That’s because they are usually more aligned.

Even founders, with much bigger stakes than a typical employee, often do not involve personal lawyers in dealings with the Company; not until the later stages when the cap table and board composition are very different. They rely much more on company counsel to advise on what’s best for the Company as a whole, which indirectly means what’s best for the common stock.

In short: Common Stockholders, broadly, (i) are less diversified, and therefore more exposed to risk in this specific company, (ii) have less downside protection, (iii) are less wealthy and sophisticated, and (iv) usually don’t have their own lawyers to review and negotiate things on their behalf. This is, to a large degree, why the case law puts such an emphasis on fiduciary duties to common stockholders.  Because the bigger Preferred Stock players can negotiate contractually for their rights and protections, Corporate Law says officers and directors should focus on what’s best for the Company as a whole, with special care toward the interests of the common stock.

ps: should Company Counsel own equity in the Company? Usually they don’t, but sometimes they do. After reading the above, it should be crystal clear what type of security they should own, and why letting your lawyers buy preferred stock can, in many circumstances, be a very bad idea.

Transparency, Risk, and Failure

TL;DR: In the very uncertain, high risk environment of an early-stage startup, the most successful founders are extremely good at practical risk mitigation. One of the most important forms of risk mitigation is to build a culture of transparency and honesty at all levels of the company; meaning people say what they’re thinking/feeling, and do what they say they’re going to do. No politics. No surprises.

Background Reading:

One of the biggest myths, in my experience, about successful entrepreneurs is that they are generally risk-seeking, risk-loving, uber-optimists who fearlessly run right into unknown unknowns, expecting things to turn out for the best. It’s just false. My word for the person I just described is “idiot.”

Yes, they are optimists, but what they’re often optimistic about is their risk mitigation skills. To an outsider, they may look fearless and indifferent toward risk. But in their mind they’re constantly analyzing risks, including seeing risks that others don’t see (the paranoid survive), and actively taking steps to address them.

In the early days of a company, without a doubt one of the largest sources of risk is, to put it simply, people. Co-founders, employees, consultants, commercial partners, investors, advisors, etc. Before your company has become a fully greased and well-running machine with an established brand, market presence, and gravitational pull, it is, in large part, a highly fragile vision of the future; dependent, to the extreme, on a handful of people and their ability to execute toward a common goal. It takes just one “bad” person, or decision, or accident, in that group to bring it all crashing down. 

Each person carries around risks; either risks that originate from them, or risks they know more about than others. Examples:

Co-founders: Are they truly satisfied with their equity stake/position at the company, and committed to the cause? Do they feel like the CEO is the right person for that position, and making the right decisions, with the right input?

Employees: Are they happy with their compensation/position, given the resources and stage of the company, or are they already planning an exit? Do they feel like the company is moving in the right direction? Are there behaviors/activities going on at the company that the C-suite should know about, but maybe aren’t aware of?

Commercial partners: Are their intentions the ones they’ve actually stated at the negotiation table? If circumstances or incentives change, will they try to preserve the relationship or at least reasonably negotiate a fair break, or will they try to maximize one-sided gains?

Investors: Do they truly believe the current executive team can execute effectively at the current stage of the company, and if not, have they communicated their thoughts to the team? If they are planning for changes, are they letting the team know, so the process can be open and balanced?

By working with people with a heavy bias toward transparency and honesty, you maximize your visibility into risks, which maximizes your ability to proactively address them. Risks that take you by surprise are 100x more deadly than those you can see coming. But what does transparency mean, and how do you find it?

Transparency means:

  • Saying what you’re truly thinking, feeling, and planning to do, instead of what may be optimal for you to convey in a short-term self-interested sense;
  • Even if you’re not the best at verbalizing your thoughts/feelings, conveying them in other non-verbal ways – transparent people tend to show more emotion. The perpetually sterile, calculated, always careful not to speak off-script demeanor that all of us encounter in business is the opposite of what you should look for.

It does not mean blurting out your thoughts at random without proper self-awareness or sense of propriety, or conveying more information than specific people really need to know. The “radical transparency” I’ve read about in some circles – for example, the idea that everyone needs to know everyone’s compensation – in my mind is asking for trouble. There is always information that the CEO has that should be heavily filtered before it gets to employee #200, and visa versa. But a thoughtful, respectful, durable culture of transparency ensures that the right information flows to the right people who truly need it and can benefit from it. 

It also does not mean always being the nicest, most agreeable person in the room.  Sycophants and glad handers may keep the peace, but at a cost of smothering you with so much bullshit that you can’t hear the things you really should be hearing. There is an art to conveying uncomfortable information, and people can be trained/coached for it, but it will always still be somewhat uncomfortable.

I’ve been very happily married for almost 10 years (this December!), but I’ll be damned if I ever tell you that hasn’t come with conflict. If anyone ever tells me that they’re in a serious, complex relationship that is completely conflict free, I hear one word in my mind, and one word only: divorce. Small conflicts prevent massive ones. If there is honesty and transparency, there will be some conflict, and it will make you stronger. 

And of course, if you’ve struggled to find, attract, and retain people who are honest and trustworthy, a very good place to analyze the problem is a mirror. Company culture is very much a reflection of the people who started it. Be the person you expect others to be.  And if you want transparency, don’t penalize people when they act accordingly.

At the end of the day, transparency is the foundation of trust in relationships, and the data is universally clear that virtually nothing helps teams, businesses, and broader networks thrive (and minimize serious conflict) better than trust. In the world of startups, there are hundreds of sources of potential failure that you are constantly battling against, and that you can’t do a lot about. Very very few risk mitigation tools are in as much of the founders’ control as the culture they implement in their team from Day 1.

Do the intentional, hard work up-front to recruit/engage people who say what they’re thinking, and do what they say they’re going to do, and you’ll maximize your chances of survival. You’ll also keep your legal fees way lower in the process.

Vesting Schedules – Beyond the Standard

TL;DR: The standard 4-year with a 1-year cliff vesting schedule is not the only option. Companies can use a number of alternatives to better align incentives, and even select for employees/founders with more loyalty and interest in long-term commitment.

This is not a post explaining what vesting schedules are – I make it a point to (try to) not duplicate content that others have already written about 10x on the web. See this post for a quick run-down.

Most people know that the “market standard” vesting schedule is 4-years with a 1-year cliff. That’s standard for employees, but also quite common for founders. I occasionally hear founders say that a founder team shouldn’t subject each other to a cliff, but generally I think that’s a bad idea. Some kind of cliff is a great way of ensuring that anyone there on Day 1 intends to be there for some meaningful amount of time. If they balk at a cliff, it says something; not entirely clear what it says, but it certainly says something of significance.

Advisors tend to have shorter schedules, like 1-2 years, because their grants are smaller and tenure tends to also be shorter. At least a 3-month cliff is always a good idea for advisors, in my opinion. If they balk, it, again, says something.  Making small, reasonable requests in any kind of relationship, and observing the response carefully, can be a great way to gauge a person’s personality, motivations, and perspective; even if you consider the request itself immaterial and easy to drop. 

However, for companies that feel like the standard approach doesn’t fit their context, or align incentives properly, there are a lot of smart alternatives that we’ve seen our client base adopt. Here are a few:

Milestone Vesting

Instead of vesting based on time, you set it to occur upon certain milestones. These can be any number of things: achieving a certain financing, a certain revenue level, hitting a sales quota, etc. Whenever we see milestone vesting, the milestones tend to be contextualized for the individual. And certainly it only makes sense to have milestones that the individual recipient of the stock actually plays a lead role in achieving.

The benefit of milestone vesting is it can, when it works, better align “earning” equity with actually delivering results, as opposed to simple tenure based on time. However, the challenges that arise are (i) in the drafting – getting people to agree on reasonable milestones, (ii) in deciding when they’ve been achieved – who ultimately decides? the Board? the CEO?, and (iii) when circumstances change and ambiguity arises as to whether the milestone has been met. And of course, it is just more of a hassle to have to track milestones for vesting purposes as opposed to just letting the clock tick.

My strong suggestion to clients whenever they go with milestone vesting is to stick to milestones with objective, unambiguous metrics. Stay away from anything that depends on someone’s opinion – like “doing X to the satisfaction of Y person.” You’re just asking for trouble if you go there. Something like “achieving $X in cumulative customer revenue” will result in far far fewer disputes. And remember to use milestones that the stock recipient plays a significant role in helping the Company achieve. That too will prevent arguments over unfairness or bad faith as to person Y being responsible for why person X didn’t get their vested equity.

Longer Schedules (5-6 years)

There is a lot of value in attracting employees who intend to be with your company for the long-haul, as opposed to those who hop between employers. The sense of long-term thinking and loyalty that a long-term employee can bring to key projects can be hugely important strategically. I’ve always found the “perk wars” of certain tech ecosystems to be somewhat counter-productive, as they tend (in my mind) to select for employees with more mercenary personalities, as opposed to people who want to be there for much more important reasons.

I’ve certainly applied that thinking to how I recruit for MEMN.  Honestly, if whether or not we offer free lunch or doggy sitting will influence your decision to work for us, I’d prefer you not.

Companies that deeply value long-term commitment will often consider having longer-than-standard vesting schedules; maybe 5 or 6 years. Of course, for this to work you generally need to provide an appropriately larger equity stake.  Someone might ask why not, instead of one grant with a longer schedule, simply committing to do another grant after the standard 4-years?

It’s true that you can do that, and the standard approach is to provide ‘fresh’ grants to employees, for retention purposes, once their original vesting schedules run their course. However, (i) a grant made years later will have a higher exercise/purchase price (for tax purposes), so it’s actually tax favorable to do an earlier grant with a larger schedule, and (ii) there’s something about a longer schedule that just signals a person’s long-term commitment better, particularly if coupled with back-weighted vesting (see below).

Back-Weighted Schedules

If you’re looking to use vesting schedules as a way to gauge long-term commitment, back-weighted vesting is definitely an option worth considering. The concept is quite simple. Instead of vesting in equal installments over a schedule, the back-end of the schedule provides more vesting than the front-end. So instead of 25% vesting per year, Year 1 may be only 10%, but Year 4 may be 40%. There is definitely some logic to this idea, because the value someone delivers to their employer tends to go up over time, as they’ve become integrated into the culture, moved up in rank, taken on more responsibility, etc.

A longer-than-standard schedule with back-weighted vesting is one of the strongest messages you can send as to how much significance the Company places on loyalty and long-term employment. And as I mentioned before, if someone really balks at the idea, pay attention to what that tells you, because it definitely tells you something.

For key hires, the standard doesn’t always fit. 

I hear it all the time: “just go with what’s standard.” I understand that approach, and it’s sometimes driven by an attitude that all of this legal mumbo jumbo doesn’t matter. Except for when it does.

For strategic hires, particularly in the very early days of a Company when your core team will totally make or break you, non-standard vesting schedules can be a valuable tool to align incentives, and “filter” for people who may not be as committed to the cause as you think they are. Remember: when someone says “no” to something you think is reasonable, it may not be fully clear why, but it tells you something. And that something can be very important.