I read David Rose’s book on angel investing during a recent holiday. It does an excellent job of explaining how professional angel investors (should) think. For those who don’t know, David is the founder of New York Angels, and is one of the world’s best known angel investors.
However, David, like many professional investors, makes one major mistake in his chapter on deal terms.
He specifies two ways for angel investors to invest: for preferred shares and for convertible debt. He thinks so little of the third alternative, common shares, that he doesn’t even consider it worthy of discussion, simply saying ‘common shares are founder shares’.
Let me explain why I feel that you as an entrepreneur should instead insist on common shares (and why if you are an angel investor, you should agree) using David’s own logic from his book.
When Do Preferred vs. Common Shares Matter?
As David points out, having preferred shares or convertible debt – as opposed to common shares – only matters in very specific cases.
Your share type doesn’t matter if the company is bankrupt. Convertible debt holders, preferred shares and common shares all get zero.
Your share type (normally) doesn’t matter in the case where the company has a large, successful exit. The preferred shares and convertible debt then convert to an equal number of common shares (if you have simple deal terms), and everyone will get the same as if they had common shares.
Share type only matters when the company does poorly, but still gets something back. Maybe the patents are sold to a competitor after the company closes down. Maybe a competitor approaches the board and acquires the company for cheap (e.g., because the investors who control the board have given up on the company, even though it has just turned around after years of struggle – as happened to one entrepreneur I know).
In these cases the money goes first to debt holders. After the debt is paid off anything left goes to preferred shareholders. Anything left after that (often nothing) goes to the common shareholders (i.e., the founders).
So the whole conversation around deal terms is ‘who gets the money if your company does poorly and is sold for pennies’. Does the investor get all the money, or is it shared with the entrepreneur?
Returns to Investors
David’s book does a good job of outlining the investor math. Out of 10 investments, you expect 5 to fail, 2 to return the initial investment, 2 to return 2-3x the initial investment and one investment to return 30x the initial investment.
According to him, 80% of your total portfolio returns come from the one in ten ‘home run’ investments. The four companies that you get some money back from represent 20% of your total returns.
So, as David’s math makes clear, the whole conversation around deal terms is really a conversation around optimizing the 20% of your total returns.
Specifically, in the 2 out of 10 cases that return 1x you would get maybe 0.2-0.3x instead if you held common shares. And in the 2 out of 10 cases that return 2-3x you might get 70% of what you would have had.
What’s the bottom line? By investing in common shares angels would get ~92% of the returns they get by investing in preferred shares or convertible debt (using David’s own math).
In 6 out of 10 deals it makes no difference. In the remaining 4 deals, by getting first call on the money – via preferred shares or convertible debt – they boost their total expected returns from their portfolio by 8%.
Risk Profile for Investors and Entrepreneurs
As David’s book also makes clear, investing in startups is ‘a numbers game’. Any professional investor should invest in at least 20 companies over a 5 year period, to be properly diversified. If one of those businesses fails – or disappoints via a 1x return – and you get $50K more or less on a $2M or $5M portfolio you shrug your shoulders and turn to the rest of your portfolio.
Over the same 5 year period, an entrepreneur can expect to be involved fulltime with around two businesses. The success or failure of each business matters very much to the entrepreneur. And if the entrepreneur gets $100,000 vs. $0 on a ‘disappointing 1x liquidation’ of the only startup in their by definition undiversified portfolio, that makes a very large difference to their ‘portfolio’ return.
For an investor, each company is one of many in their portfolio. For the entrepreneur, each company is years of their life.
What happens to an investor on any company other than their ‘home runs’ may impact their returns by 1-2%. For an entrepreneur, getting some piece of a ‘disappointing’ exit may be 100% of their portfolio returns, and may dictate whether they can start another company, or will be forced to look for a salaried job.
What’s Wrong With This Picture and How Do We Fix It?
David rightly states that ‘truth number one is most startups fail’.
His math further makes clear that for the angel, what really matters is the return from their ‘home runs’ – which is 80% of their portfolio returns. They are protected against any individual failure by diversification. The added downside protection they get from having preferred shares or convertible debt gives them an extra 8% portfolio return.
Entrepreneurs by definition aren’t diversified. If funded by an angel group, by David’s numbers they are facing a 10% chance of being a huge success, a 40% chance of being a ‘disappointment’, and a 50% chance of failing outright. Whether they get any money or not in the ‘disappointing’ case is really important to them. They lose a lot by giving up the preferred share or convertible debt, and would be far better to give the investor common shares.
In any negotiation you are looking for win-win scenarios. There is an obvious one here.
The diversified angel should take more in a big win, the undiversified entrepreneur should make sure they have a better chance of walking away with something. The approach is exactly as I covered in earlier posts.
Entrepreneurs should agree on a valuation, and then ask the investor what additional discount they want to take common shares instead of preferred shares.
The ‘common share discount’ should be around 15-20%. This gives the investor a net 10% boost on their portfolio return (the winners produce 15-20% more), which investors like David should be delighted by. And it means the entrepreneur has a 50% chance of walking away with something, even if the business gives only a ‘disappointing’ return.
What About Moral Hazard?
Is there a reason unrelated to portfolio theory to insist on preferred shares or convertible debt? Do entrepreneurs funded via preferred shares or debt work harder because they lose everything if the deal isn’t a massive success? Will an entrepreneur be tempted to sell out cheap if the investor doesn’t have a liquidation preference?
To answer this (since I don’t have any studies) let me return to David’s advice.
His advice on investing is that your first priority should be to pick great entrepreneurs. How does he define a great entrepreneur? After the baseline requirement of being able to trust the entrepreneur, his number one requirement is passion.
If your entrepreneur is driven by passion – as most good ones I know are – you don’t need to worry about them working any harder or not because of a specific clause in the terms sheet. They are motivated by the business, not the money.
If anything, the moral hazard exists the other way round.
Investors are largely motivated by money, not the business. When they invest via preferred shares or convertible debt, they often (e.g., the case I mentioned earlier) do things that are against the interest of the company and all other stakeholders, just because it is in their own interest.
This risk of investors acting against everyone else’s interests is a very strong reason for entrepreneurs to insist that investors take common shares.
Of course to get this result entrepreneurs should not appeal to the investors’ morals. Appeal instead to their self-interest: bribe them with more shares, i.e., a lower initial valuation.
How About ‘Last Money in Makes the Rules’?
Many investors who are fully in agreement to here may still object to taking common shares, because of a concern that a later investor make take advantage of ‘last money in makes the rules’ to get preferred shares, putting all common shareholders – which now includes them – in a disadvantaged position.
Just the fact that this is a likely concern to investors shows why preferred shares aren’t a great choice. Investors are fine doing it to founders, but don’t want it done to them?
One possible solution, which you would have to check with your lawyer, might be to add a clause to the shareholder agreement, giving all prior investors the option to convert their common shares in the event the company issued any convertible debt or preferred shares. The common shares could convert to the preferred shares or convertible debt based on some formula (hey, you’re not expecting me to write the whole contract for you, are you?).
Having this clause in your shareholder agreement will make it much easier to negotiate with later investors: ‘if I give you anything other than common shares, I have to give it to everyone.’
Common Shares Just Make Sense
I could talk further on why common shares make sense as standard deal terms from a healthy overall ecosystem point of view, e.g., it builds in full alignment, and makes it easier for entrepreneurs to stay in the game and grow even if their first deal isn’t a home run … and it reduces the number of entrepreneurs who feel screwed by investors.
It isn’t necessary to appeal to people’s higher selves with this ‘health of the ecosystem’ argument. It’s also in their own self-interest.
For an entrepreneur, the arguments are all in favor of common shares. Startups are risky: you can diversify by making sure you get something/more back in the 4 in 10 cases when the success is only modest, rather than having deal terms that mean you need the unlikely 1 in 10 case to get anything. You also keep your investor’s interests fully aligned with yours. The cost? A few more shares, i.e., make a little less money in the 1 in 10 case … when you are already a huge success.
For an angel, it’s a very simple tradeoff.
Do you want to optimize the 80% of your portfolio returns and make more from your successes, by trading your downside protections against a 15-20% valuation lift? Or do you want to keep optimizing the 20%, by taking preferred shares or convertible debt that let you walk away with the total sales price if the company is sold for pennies?
David Rose makes it clear that your portfolio returns come from the 80%, not the 20%. So why not shift to better priced, common share deals?
Making it Happen
The conclusion is simple.
If you are an entrepreneur, insist on common share deals (and send your investors to this blog post if they don’t understand why).
If you are an investor, look at the numbers. Deal terms like common vs. preferred shares are a straight financial calculation. Since you make most of your money on the big wins, take more from them rather than fighting over pennies in your failures. Take common shares – at a 15-20% better price – over preferred shares and debt. The entrepreneur, the ecosystem, and your wallet will all thank you.