After 5 years of buying common stock in startups, I’ve learned a few things.

Rather than the typical 10-page venture capital term sheet packed with terms and restrictions, our team believed that a much simpler structure in which we owned the same security as the founders would align interests, boost trust, and, ultimately, improve the performance of our investments.

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As we near the end of our second fund’s investment and the start of our third, we felt it would be a good opportunity to reflect on whether owning common stock rather than preferred shares has provided the benefits we had hoped for.

How preferred stock might cause incentives to be misaligned between investors and startups

To remind you, there are other terms and conditions in a Preferred term sheet that might misalign investors and founders; I’ll only highlight two below for brevity. See the Term Sheet Grader for further information.

Preference: Preferred stock has a ‘preference’ that allows the investor to pick whether they want their money returned or a percentage of the total proceeds. In the worst-case situation, an investor returning their money could entail taking a much bigger percentage of the earnings than the founders “thought” they sold.

For example, if an investor buys 25% of a company in the form of Preferred Stock for $2 million, their break point is $8 million (which happens to be the post-money valuation of the round). The investor would rather get their $2 million back if the company is sold for less than $8 million. If the company is sold for more than $8 million, the investor will take 25% of the proceeds.

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The founder believes they sold 25% of their firm, however the percentage is decided by the price at which the company is sold. Yes, if the company is sold for $8 million or more, the investors will receive 25% of the proceeds, but if the company is sold for $4 million, the investors will receive $2 million, or 50% of the proceeds. Worse yet, if the company is sold for only $2 million, investors will receive the entire sum.

Anti-dilution: This clause states that if an investor purchases shares for $10 and the business raises funds at a lower price point in the future, the investor’s share price will be recalculated to a lower price. How is this accomplished? By issuing more shares to investors, the rest of the ownership pie, particularly the founders and employees, is diluted. The business isn’t doing well, and the investors are being compensated at the expense of the founders. Aligned? Hardly.

In actuality, the qualities of preferred stock have virtually little beneficial impact on making money as a seed stage investment. These preferred stock attributes all wash away when all invested cash is converted to common shares for major victories – the primary drivers of returns in the VC business. Preferred terms rarely matter when a startup underperforms or fails since there is little or no pie to divide in the first place.

We adopted a different approach, focusing our efforts on establishing the greatest possible environment in which to achieve large results, rather than worrying about the ‘cents on the dollar’ we could have gotten in lower-performing companies if we had negotiated better terms. We gave up downside protection in exchange for more upside potential.

Pillar’s Common Stock Investments in Fund 1 and Fund 2 in a nutshell

Pillar has invested in 45 firms with its first two funds of $57 million and $100 million. We’ve allowed the founders select whether we buy common or preferred in the rounds we’ve led. We bought common stock in 11 firms. Petri Bio (Pillar’s bio+tech accelerator) has made 11 investments, all of which are publicly traded. There are 56 corporations in total, 22 of which are common, accounting for 38% of the total.

The Common Stock Approach’s Successes

When we first considered buying common stock, we wanted to build a stronger bond of trust. It wasn’t about getting the incremental bargain or out-marketing our competition in any way. It stemmed from a desire to be nice and aligned. After five years, we are confident that purchasing common shares has helped founders understand that we are on their side, resulting in more trust and better, faster decision-making.

Still, we acknowledge that for certain investors, a higher level of trust may not be enough of an advantage. Perhaps The Pillar’s most valued investments are agreements our staff completed on a regular basis.

We’ve made a number of investments where the founders were either uninterested in VC if it came with the conventional ‘trimmings,’ or they selected Pillar, regardless of structure, because our willingness to acquire common indicated that we “walked the walk” on alignment.

Investing in common stocks has taught me a lot.

There are things we’ve learnt that have surprised us, as well as problems we’ve had to face, as with any experiment.

First, we were taken aback when some entrepreneurs asked us to purchase preferred stock instead of common. Why did this happen a few times throughout our first two years? Because other investors (whom they intended to include in the syndicate) or, paradoxically, their own legal counsel talked them out of it.

Why would corporate counsel encourage founders to take the “standard contract” instead of something that would clearly benefit them? Mostly because they’ve never done it before and are afraid of the unknown. The fast response you’ll hear from counsel, for example, is that allowing investors buy common shares will mess up the pricing of their employee stock option plan. They would know it does not if they spent just a few minutes learning about it. In these circumstances, 409A valuation firms know how to handle option pricing, and the price is still far lower than what investors paid. We’ve done it before and had no problems.

Voting thresholds are a second, more nuanced topic. As a firm grows and new investors join, it’s common for investors to haggle about what voting threshold is required to approve major corporate decisions. This is commonly expressed as “2 out of 3” or “3 out of 5” investors, but it is documented as a precisely calculated percentage, such as the number of investor shares required to authorise a new financing, which is 64 percent.

Should we include our common “investor” shares in this computation, or not? This isn’t a disagreement between us and the firm; in fact, the corporation usually wants us to be included because we’re the most likely to be on the same page. New investors, on the other hand, may have a problem with this because they would prefer to have greater control over these decisions. They’ll try to set limits depending on their preferred holdings.

It’s akin to the question of whether a new Series B will take precedence over the existing Series A. This is a battle between new and old investors, but the company’s strength (and capacity to hold the line) is a key factor. A and B will be pari passu if the company is in a strong position; if the company is in a weaker situation, B will be senior to A.

Finally, while we were willing to sacrifice downside protection for upside potential, we have yet to see the downside materialise in such a way that our preferred investment would have outperformed a common investment. That moment may come, but so far, buying common stock has only benefitted us.

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