Post Category → Power

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.

Ask the Users

TL;DR: Blogs, social media, and public endorsements are all noisy, and often false, signals about a person’s real reputation in the market. The only way to get the truth is to “ask the users,” and in a way that allows them to speak the truth without negative repercussions.

I’m going to keep this post as simple as possible, because the message, though extremely important and often lost on people, is quite simple.

Should you join a particular accelerator?

Ask the users – the companies that have already gone through it.

Should you accept money from a particular fund or investor?

Ask the users – the portfolio companies that have already taken money from them and gone through ups and downs.

Should you work with a particular mentor / advisor?

Ask the users – the companies they’ve already advised.

Should you use a particular law firm, accountant, or other service provider?

Ask the users – their existing clients, particularly the ones who’ve gone through a major transaction.

One of the most dramatic, impactful things that the internet (and services like LinkedIn, AngelList, FB, Twitter) has done is made it 10x easier to connect with other people to get direct, unfiltered, off the record feedback on their experiences in working with others. It has made BS a whole lot harder, and ultimately improved behavior across the board. But that brings up some important points worth keeping in mind as you “ask the users”:

A. As much as the web has made finding direct feedback easier, it’s also magnified the opportunities for untruthful marketing.

Blogging and social media are great ways to get a feel for a person’s persona – or at a minimum the persona they want to display publicly, which itself is a valuable, albeit noisy, signal. However, never underestimate the capacity for sophisticated players to whitewash their online reputations. What you see on a blog, on Medium, or on Twitter is marketing, and it’s only with due diligence that you verify it’s accuracy.

And yes, that speaks for this blog and my own social media presence as well.

B. Do not assume that a public-facing endorsement is reflective of that person’s true opinion.

Reality check: people use public endorsements as currency. A VC will make their investment, or assistance on some project, contingent on the expectation that founders say a few glowing things about them on Twitter. A lawyer will agree to discount a fee if they can get a great LinkedIn recommendation. An accelerator will make an intro if the founders will write a great Medium post.

Public endorsements, though valuable as a signal, are fraught with ulterior motives. In short, they can be, and often are, bought.  I know plenty of people who, for some quid-pro-quo arrangement, have given public endorsements for market players whom they would NEVER recommend privately. Do not take a favorable public comment as reason to avoid doing private, off the record diligence.

C. Ignore the opinions of sycophants.

Every ecosystem is full of people who will sing the praises of anyone influential simply because that influential person could get them business. It may be too far to call some of them spineless, but ultimately they lack the personal brand independence to speak accurately about other peoples’ behavior. No one is perfect, and if someone’s review of a particular player feels totally over-polished, it’s probably because they’re not telling you the truth.

You want feedback from serious, honest people who are willing to speak their mind (but see below).  Not a bunch of random cheerleaders.

D. Talk privately, and don’t reveal whom you’ve spoken to. 

No one who has an active, ongoing relationship with someone wants to damage that relationship, even if they’re not entirely happy with it. Doing so is irrational. If I’m in an accelerator, I still depend on that accelerator’s support, so don’t expect me to go on the record for badmouthing them. The same goes if I’m in a particular VC’s portfolio, or working with a particular law or accounting firm.

This is why it’s extremely important to do “blind” diligence; meaning if you are diligencing X by asking Y, you absolutely do not want X knowing that you asked Y. If a VC tells you to ask a specific company about their experience in working with them, then they know exactly whom to punish if you end up walking. If you go through their portfolio and personally decide whom to ask, you remove that ability, and therefore dramatically increase the likelihood that you’ll get honest answers.

And it should go without saying: phone calls or in-person meetings. Don’t expect honesty in a forward-able e-mail.

E. Focus on patterns, not a single review.

Even the best restaurants have the occasional negative review because they either were having a bad day, they simply weren’t a good fit for the particular patron, or – and let’s be honest here – sometimes the user is a pain in the ass. The customer is always right? Nope, sometimes the customer is a moron.

Don’t assume that you’ve got the full picture from simply asking one person. Ask a few, and the line drawn from the dots will matter much more than the individual data points.

F. If you can’t diligence, you need a right of exit. 

The stakes are highest for relationships that you really can’t extricate yourself from. A serious investor is the clearest example. Never take money from a VC without performing diligence.

However, for other service providers – take an advisor/mentor for example – there are other mechanisms to de-risk things. If they’re getting equity (which they often are), a “cliff” on their vesting schedule is the best one; typically 3 or 6 months. That should be enough time to understand the reality of working with them, and make corrections if it’s a terrible experience. Solid contracts help here, with clear, painless rights of termination.

However, a word of caution – all the contracts and lawyers in the world will not protect you from the enormous cost and time suck of working with sociopaths. Even if you don’t have the time or ability to diligence their “users,” you should at a bare minimum vet them personally with interviews, questions, and other ways to get a general feel for their personality and values. If you have good instincts for judging people – and if you’re a CEO I hope you do – you will be able to filter out most assholes.

Not Building a Unicorn

TL;DR: In a market that has historically idolized huge, splashy financings and exits, an increasing number of entrepreneurs are realizing that everyone else’s definition of success – particularly among certain large VCs and the general Silicon Valley community – isn’t necessarily aligned with their own.

While I’ve worked with a few companies in Silicon Valley, the vast majority of my clients are either in Austin or ecosystems that look much more like Austin than SV; “second tier” tech communities. Over time it has become crystal clear to me, and has been confirmed by CEOs I work with who spend time in both places, that the SV community has a far more binary outlook on business success than “normals” do. There is very little time for, or interest in, companies that would legitimately call a $50MM or $100MM exit a true success.

This is most clearly highlighted in the “unicorn” boom we all saw over the past few years, where founders raised very large rounds, with terms very onerous to the underlying common stock, hoping they could eventually justify billion dollar valuations to skeptical acquirers or public market investors. The result of the binary philosophy is, in fact, truly binary outcomes for founders. The handful who truly succeed at justifying their valuation in an exit achieve “buy a yacht” level wealth. And those who in a different world may have built a business that made them “merely rich,” walk away with virtually nothing; their stock under water. 

A good portion of the newer generation of entrepreneurs has, in my opinion, wised up to this reality; certainly outside of SV, where I work. They’re thinking much harder about what kind of business they want to build, and what kinds of people and resources they want to use in building those businesses. And many are accepting, and even flaunting, the fact that, while they absolutely want to achieve success and wealth, they have zero interest in following the conventional “unicorn track.” The below is a list of issues that founders should keep in mind when deliberating on their own desired path to scaling their companies.

1. The binary “get yacht-level rich or die trying” mindset is driven, first and foremost, by large institutional investors. 

Success for institutional VCs is driven not by absolute dollars returned, but by % returns on capital. If I put in $2MM and get out $10MM in a $50MM exit, that’s a solid 5x return. But if I put in $10MM and get out $15MM in a 50% larger exit, that was still a waste of my time; only 1.5x. Large funds write larger checks because they lack the mental/resource bandwidth to actively manage a portfolio of smaller investments. Most individual VCs can only support about 7-10 companies at a time. And large checks require very large exits to achieve good returns.

Entrepreneurs sometimes assume that accepting money from a large fund is better than a smaller fund, because they have more “dry powder” to deploy for follow-in financings, but this is a dangerously simplistic way of assessing investors. A large fund is much more likely to get impatient with an executive team if the business is growing, but not growing fast enough for their needs. Align yourself with a fund whose exit expectations are not totally misaligned from your own.

2. Higher valuations almost always require larger rounds, which drive binary outcomes.

Some founders assume that a higher valuation is always better than a lower one, but they are wrong.

First, investors will sometimes be willing to take a higher valuation if it means getting a heavier liquidation preference. Should you accept a 3x liquidation preference with a $15MM valuation instead of a 1x preference at a $8MM valuation? If you’re confident you’ll get a huge exit, maybe. But for normals the answer is almost certainly no. That 3x preference has dramatically increased the hurdle you need to clear in an exit before the common stock (you and your team) get anything, and it will likely get duplicated in future rounds. Onerous liquidation preferences push the common stock further under water, and increase the likelihood that the common will get little or nothing in a “merely rich” exit.

Secondly, most institutional investors have a minimum post-closing % they need to own in order to justify an investment. By driving the valuation up, you’re usually not reducing your dilution in the round; you’re just increasing the size of the check they need to write in order to get to their desired %. That can be good if you truly believe every dollar will lead to more than an extra dollar in an exit, but keep in mind that liquidation preferences are tied to dollars in by investors. If the investors have a 1x preference, a $5MM round means the investors have to get $5MM back before founders get anything; and the same is true for a $15MM round. More money raised means more liquidation preference, which again means a larger hurdle to clear in an exit before the common gets anything. Large rounds, again, drive binary outcomes.

When an investor tells you that you should keep your Series A smaller, they truly are sometimes doing you a favor. And, sorry, but if you know you’re not building a unicorn, don’t talk to your investors about why you should get that lofty valuation just because X or Y company in SV got it too. Likely exit size ties directly to what seed or Series A valuation is appropriate.

3. Angels/Seed Funds v. Institutional VCs think very differently.

Put the above two points together, and it shouldn’t require very much explanation for why Angels and Seed Funds tend to be more amenable to “merely rich” exits than large VCs. They write smaller checks at earlier, lower valuations, and therefore an exit that wouldn’t move the needle for a large VC still looks great to them. Obviously they too prefer larger exits over smaller ones, but their definition of success is still much more aligned with “normal” entrepreneurs.

Angels and seed investors may want enormous exits, but large institutional VCs need them, and they behave accordingly.

We’re increasingly seeing entrepreneurs who take on angel and seed fund investment, but are much more cautious when it comes to larger institutional checks. And as online tools and new ecosystem resources (i) allow angels and seed funds to syndicate larger early-stage rounds, and (ii) un-bundle the value-add resources once limited to larger funds, non-institutional Series As (or larger-than-usual seed rounds) are going to continue to be a thing.

It can often take a few years of being in the market to get a clearer picture of what kind of company, in terms of size, you’re likely building. It can be a good strategy to avoid making a hard commitment to an investor with hyper growth needs/expectations until you have that clarity. 

4. Understand the tension between “Portfolio” v. “One Shot” incentives.

Listen to enough VCs at large firms w/ broad portfolios talk about startup finance, and you will inevitably hear the term “power law” come up. In short, they’re referring to the fact that most of their investments either fail or merely return capital, and it’s the grand slams that make up for the other losses.

This is the distributed portfolio mindset; i’ve got stakes in a lot of companies, so it’s OK if most fail, as long as I get at least one unicorn. In fact, if I push them all to try to be a grand slam, I’m more likely to get at least one. On the others, at least I’ll get my money back before anyone else does.

The fact that (i) investors have a liquidation preference that prioritizes the return of their capital in an exit, and (ii) their money is distributed across a diverse portfolio, means that they are structurally far more inclined to favor fast growth paths that produce a handful of very large exits even if they also produce a larger number of companies for which the common stock get nothing. At its core, this is precisely why the idea that founders/employees (common) and institutional investors (preferred) are “fully aligned” economically is completely laughable. 

A strategy that maximizes returns over a diversified portfolio with significant downside protection can completely screw individual stockholders whose own stakes are limited to one company, and at the bottom of the preference stack.

Startup ecosystem “cheerleaders” who lament the lack of billion-dollar, headline-making companies in their city reflect part of this portfolio mindset as well. If I’m not toiling away for 10 years on one company, but stand to benefit from the broader ‘ecosystem,’ I may also favor a business philosophy that pushes entrepreneurs to build big, splashy unicorns (large rounds, very fast growth), or otherwise crash & burn.

Reality check: entrepreneurs don’t have portfolios, and don’t have liquidation preferences. They have one shot, and they’re slogging away 5-10 years for that one shot; not for your “ecosystem.” If I have 100x skin in a single game over everyone else, I’m going to have a fundamentally different outlook on how that game should be played.

When I hear someone complain that Texas hasn’t seen a lot of strong tech IPOs recently, my response is “so there’s no other way to be successful?” Why should we favor 1 billion dollar company over 10 $100MM companies, or 20 $50MM companies? I can think of a few arguments for why the latter is actually more robust long-term from an economic standpoint, even if it produces fewer NYT articles. It certainly provides more variety.

Obviously it’s great when any city sees a true breakout, international brand-building tech company emerge. And Silicon Valley produces, and likely will continue to produce, the lion share of those.  But those of us sitting on the sidelines, and not toiling away on one egg in one basket, need to be humbly mindful of how our discussions on success play out in the lives of entrepreneurs and employees actually doing the work.

Elon Musk. Steve Jobs. “Change the world.” “Put a dent in the universe.” “Move fast and break things.” “Shoot for the moon; you’ll land…” yeah, ok, I think we all get it. Can we please let some entrepreneurs “just” build successful companies that make their stockholders “merely rich” – and skip the super hero cape, global domination, rocket ship, and mythological creatures? There is a big, lucrative world in the space between “small business” and “billions” that many smart, ambitious people are happy to fill. 

I think the greater awareness of this issue, and the overall shift in thinking among entrepreneurs, is an extremely healthy development for everyone. It will lead to more sustainable companies, and a healthier entrepreneurial culture. If you’re building the next Facebook, by all means go ahead, and align yourselves with people looking for a ride on that train. But the other 99.999% of the world doesn’t need to apologize, at all, for building companies that are “merely successful.”