Common vs. Preferred

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Essays

Yesterday, inspired by a dinner conversation I was having with an old friend, I started musing about the common vs. preferred difference.

He had remarked that, as an employee of a startup, the risk and amount of effort (including opportunity cost) that goes into being part of the success of the business seems to not be commensurate with the incredible amount of rights (voting, information, pro rata, etc) that come along with being an investor. He asked me “why is sweat equity so much less protected than preferred equity, if sweat equity is so much harder, so presumably more valuable?” His instinct was that something about that didn’t seem fair. I had a lot of good reasons for why it’s better for the investor, but didn’t have a good answer for him about why it’s better for the company, or for the employees. So, comme toujours, I took to Twitter for help. Here are some of the thoughts that emerged:

An equity investment is a negotiated contract around future performance. The management pitches that they will do X (based on how they have performed to-date). The preferred ‘bullets’ protect the investor if the management *undershoots* X. If they *outperform*, then common actually equals preferred, because the valuation rises quickly, and the management has optionality in attracting future capital.

— Any human on the planet can sweat. Capital is scarce. This was far more true in the early days of venture capital, when innovative startups were harder to understand, and the capital willing to take a risk on an early entrepreneur was much more scarce. But the convention still holds that smart money is rarer than sweat.

— A return on sweat is harder to value than a return on a dollar. If I, as a founder or an employee, put my time into a startup, I can earn many types of rewards, including friends, a network, a reputation, and learning. If I, as an investor, put my money into a startup, the only accepted return that makes the investment ‘worthwhile’ is more money. So, making $100 after putting $0 in is quite different than making $100 after putting $40 in.

— It’s cyclical. While interest rates are low and institutional investors are pushing capital into funds (and therefore startups), employees and entrepreneurs think this way and push for stronger common stock. But when it’s the opposite, like in the early 2000s they’ll just be glad to have a salary.

If you’re wondering why your investor will get paid in an exit before you do, or why your investor will earn twice their money before the employees earn anything, or why your investor gets to vote on whether your next potential hire should get an offer, above are some of the thoughts as to why. Of course, preferred is a catchall phrase referring to a diverse set of rights, reps, and warrants, which run the gamut from being totally fair to highly unfair. Perhaps more on that later. But I was just wondering about the concept of preferred, in and of itself.

Part of me wonders if the unionization of the entrepreneurial (and early employee) class through YCombinator and other similar guilds will more permanently adjust these dynamics, such that the common stock has more teeth than it previously had. Perhaps, in a post-AWS world, if the capital sources continue to look for yield in this asset class, and as unique founders have more and more control over the fates of their early products, there will be a sea change in how the classes of stock are allocated.

I’m not making a judgment call on whether it is good or bad, so much as wondering about the convention, and if it’s safe to assume that it will stay as it is. As an investor, protecting upside (so, reserving the right to continue investing in the company as it goes well) is an extremely important part of earning returns. And frankly, healthy returns in the asset class — that is, to venture funds — are *critical* to the ecosystem remaining vibrant, and to startups getting risk capital, while they are still figuring out how to make an impact. But it is quite interesting to consider the implications of a stronger common stock class, and what that might do for my job, and for my peers in venture.

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