Why VCs Should Primarily Invest in Startups Using Common Stock

VC firms have traditionally used preferred stock as their go-to investment vehicle when funding startups. However, there's an argument that common stock should be the way for VCs to invest in early-stage companies. This article explores the reasons behind this thinking and provides examples to illustrate the benefits of using common stock for both investors and entrepreneurs.

Alignment of Interests

One of the most compelling reasons for VCs to use common stock is the alignment of interests it creates between investors and founders.

Example: Imagine a startup, InnoTech, raises $5 million at a $20 million post-money valuation. If the VC uses preferred stock with a 1x liquidation preference, they're guaranteed to get their $5 million back before common stockholders (typically founders and employees) see any returns. This can lead to misaligned incentives in challenging situations:

• In a downside scenario, where the company is struggling but still has some value, the VC might be inclined to push for a quick exit to recover and recycle their investment, even if it means a low valuation that leaves little or nothing for common shareholders.
• Conversely, founders might resist a modest but fair acquisition offer that would provide a return to the VC, because they would receive little to nothing due to the liquidation preference.

By contrast, if the VC invests using common stock, they're in the same boat as the founders. Both parties are incentivized to grow the company's value as much as possible, as their returns are directly proportional to the increase in the company's overall value. This alignment can lead to more collaborative decision-making, especially in difficult times, as all parties share the same upside and downside potential.

Simplified Cap Table

Common stock investments lead to a cleaner, more straightforward capitalization table.

Example: Consider a startup, DataDrive, that goes through multiple funding rounds:

• Seed: $2M on common stock
• Series A: $5M on common stock
• Series B: $10M on common stock

With this structure, all investors and founders have the same class of stock. This simplifies decision-making processes, reduces potential conflicts, and makes it easier for new investors to understand the company's ownership structure.

Easier Follow-On Investments

When VCs invest using common stock, it can make follow-on investments simpler and more attractive.

Example: A VC firm, FutureFund, invests $3 million in a SaaS startup, CloudSolution, using common stock at a $15 million valuation. Two years later, CloudSolution is growing rapidly and needs additional capital. Because FutureFund holds common stock, they can participate in the next round without worrying about how it might affect their previous investment terms or preferences.

Attractive to Founders

Using common stock can make a VC firm more attractive to high-quality founders who are increasingly aware of the downsides of complex preferred stock structures.

Example: Two competing VC firms approach a promising AI startup, Alphanome.AI. Firm A offers $10 million for preferred shares with a 2x liquidation preference and other complex terms. Firm B offers $10 million for common shares. All else being equal, the founder is likely to prefer Firm B's offer, as it demonstrates a willingness to succeed or fail alongside the founders.

Simplified Exits

Common stock can simplify the exit process, whether through an acquisition or an IPO.

Example: Consider a startup, GreenEnergy, that's acquired for $100 million. If the VC had invested $20 million for preferred shares with a 2x liquidation preference, they would be entitled to $40 million off the top, leaving $60 million for common shareholders. This can create tension and complicated negotiations. With common stock, the distribution is straightforward – if the VC owned 20% of the company, they would receive $20 million, proportional to their ownership.

Long-term Value Creation Focus

Common stock encourages VCs to focus on long-term value creation rather than short-term protection.

Example: A VC firm, GrowthPartners, invests $8 million in a biotech startup, GeneCure, using common stock. Because they don't have downside protection through preferred stock, GrowthPartners is incentivized to provide more than just capital. They actively help with strategy, connections, and operational support to ensure GeneCure's success, as their returns are entirely dependent on the company's growth.

The Illusion of Downside Protection

One of the primary arguments for using preferred stock in VC investments is the downside protection it offers. However, this protection is often illusory in practice, especially in early-stage investments.

Example: Consider a VC firm, TechVentures, that invests $5 million in a promising startup, AIRevolution, using preferred stock with a 1x liquidation preference. The idea is that if AIRevolution fails or exits at a low valuation, TechVentures will at least get their $5 million back before common stockholders receive anything. However, the reality of startup investing is that when companies fail, they often do so spectacularly, with little to no assets left to liquidate. If AIRevolution burns through its funding and shuts down, there may be no meaningful assets to recover, rendering the liquidation preference worthless. Furthermore, in scenarios where a startup is struggling but still has some value, the downside protection can actually hinder a beneficial exit. For instance, if AIRevolution receives an acquisition offer for $3 million, the common stockholders (including founders and employees) would have no incentive to approve the deal, as they would receive nothing due to the liquidation preference. This can lead to a situation where everyone loses, as the company may eventually fail completely instead of achieving a modest exit.

Statistical Perspective

Research has shown that the vast majority of returns in venture capital come from a small percentage of highly successful investments, just 6% of investments returned 60% of the total gains in their portfolio. This power law distribution of returns means that the real upside in VC comes from the big winners, not from minimizing losses on the downside.

More Realistic Startup Valuations

Investing via common stock can also lead to more realistic and sustainable startup valuations, benefiting both investors and founders in the long run.

Example: Consider two startups, A and B, both seeking $10 million in funding.

• Startup A receives an offer from a VC using preferred stock with a 1x liquidation preference, multiple participation rights, and other protective provisions. The VC agrees to a $50 million pre-money valuation, resulting in a $60 million post-money valuation.
• Startup B receives an offer from a VC using common stock. After negotiations, they agree on a $40 million pre-money valuation, resulting in a $50 million post-money valuation.

At first glance, Startup A's deal might seem more attractive due to the higher valuation. However, this valuation is often inflated to compensate for the additional rights and protections the VC receives through preferred stock. The common stock valuation for Startup B, while lower on paper, often represents a more accurate assessment of the company's true value.

Benefits of Realistic Valuations:

Sustainable Growth: More realistic valuations set achievable growth targets, reducing pressure on founders to meet unrealistic expectations.

• Easier Future Fundraising: Companies valued realistically in early rounds find it easier to raise subsequent rounds, as they're more likely to show the growth that justifies their previous valuation.
• Reduced Down Round Risk: Inflated valuations increase the risk of down rounds in future fundraising, which can be demoralizing for teams and send negative signals to the market.
• Clearer Employee Equity Value: When common stock is used, employees with stock options have a clearer understanding of their equity's potential value, as it's not subordinate to complex preferred stock structures.
• Aligned Incentives for Exit: Realistic valuations based on common stock reduce the likelihood of scenarios where only the VC benefits from an exit due to liquidation preferences, as all shareholders are on equal footing.

Shifting Focus

By using common stock and foregoing the illusory downside protection, VCs can:

• Simplify deal structures, leading to faster closings and less negotiation overhead.
• Build stronger long lasting relationships with founders by demonstrating true alignment.
• Focus their energy and resources on maximizing the upside potential of their investments, rather than trying to minimize losses on likely failures.

This approach acknowledges the inherent risk in startup investing and embraces it, potentially leading to better overall portfolio performance and healthier startup ecosystems.

While preferred stock has been the norm in VC investing for decades, there's a strong case for shifting towards common stock as the primary investment vehicle. By aligning interests, simplifying structures, focusing on long-term value creation, and recognizing the often illusory nature of downside protection, common stock investments can lead to better outcomes for both VCs and founders. The shift away from an overemphasis on downside protection acknowledges the reality of venture investing: that returns are driven by outlier successes, not by minimizing losses on failures. As the startup ecosystem evolves, we may see a gradual shift towards more common stock investments, potentially reshaping the dynamics of venture capital and fostering a more aligned, transparent, and effective funding environment for innovative companies.