Great Risk Merits Great Reward

Below is the “Tip of the Week” transcript from the Podcast Episode 10: The Term Sheet feat. Brad Feld

Upon an investment, an angel investor can receive either Preferred Stock or Common Stock. The key thing to note in Brad’s overview, is that the Preferred Shareholders can choose to be paid their liquidation preference, prior to the common shareholders. So just b/c you have 20% equity in a company, if it’s common stock, you may not get 20% of the proceeds. While Brad, mentioned that a 1x liquidation preference is standard, I have received term sheets, from entrepreneurs that already had a lead investor, that include 2x and 3x liquidation preference.

There are also a number of other rights that are often secured through preferred stock. For example, pro-rata rights, that we discussed last week. Also information rights, rights of first refusal, co-sale rights, anti-dilution… while we haven’t covered all these items, it becomes clear that preferred stock is a way to protect and support one’s investment.

On top of that, as we touched on, if later stage investors negotiate for participation, then they will get their original investment, or some multiple of their original amount, back before the common shareholders equity percentage is applied to the remaining capital. I recently had an opportunity to invest in a very exciting startup in Chicago called Scholastica. It is run by some University of Chicago alums that have a vision to re-invent the publishing industry… and, I believe, that have a real good shot of doing just that. After running them through my evaluation process, they scored very high, and it was a GO. Unfortunately, I was not a participant in their round. Ultimately, the reason I didn’t proceed was because their offering was for common stock and while I would love to have a piece of this company, the risk of being watered out of a cap table by subsequent, later-series, preferred investors is high. A great fear, that every investor is trying to avoid, is having a huge win… only to have it yield a small return b/c the investment was not appropriately protected. Now, this company did successfully close their fundraise round. I’m happy for them and wish them the best success. This is not a knock on them. It’s not them that will cause an issue later on, it’s the subsequent VC investors that will requre preferred stock and may negotiate for participation. And it is the startup’s right to raise money at the terms they prefer and clearly, there were other investors that did not think the risk of common stock should preclude an investment… but for me, a big win must yield a big return, and the risk was too high. Hopefully they do another raise in the near future, and I can get in…. maybe at a higher valuation, but in a preferred position.

So step back and remember the industry that we’re all in… it is inherently risky and a few great successes must compensate for a number of losses. Venture investing enables both change and evolution as well as disruption and revolution. As an investor, you are empowering innovation, value creation and helping shape the future… something few investors in other asset classes can claim. And great risk merits great reward. As a venture investor, if you choose well, you’re entitled to it.