One of the standard debates between angel investors and entrepreneurs is whether or not angel investments should be for common stock or preferred stock. Common stock is the same stock the founders have and usually doesn’t have any special rights. Preferred stock is senior to the common stock where in the event of a sale of the business, the preferred equity holders get paid at least their money back before the common shareholders. Unfortunately, this really only matters when the business sells for less than the post-money valuation when the capital was raised (downside protection).
Here are a few thoughts on angel investors buying common or preferred stock:
- Preferred stock, in the form of 1x non-participating preferred, the most standard type, really is for protecting the downside of a deal so that in a less-than-ideal exit there’s a better chance the investors at least get their money back
- Preferred stock also has anti-dilution rules associated with it so that some level of protection is in place in the event more stock is issued later (e.g. for fundraising or more employee stock options), which again is protecting against the negative
- Angel investors that have been successful, through luck or skill, will often say that protecting the downside doesn’t do much since all the success is through the huge winners, not the small losers (e.g. when a startup does great, everyone wins and it makes up for other losses)
- Convertible debt often converts into equity once a certain amount has been raised, and this is usually for preferred stock
Personally, I’ve invested in both common and preferred stock as an angel investor but I believe preferred stock is the way to go for angels. Providing extremely risky seed stage capital warrants getting paid back first in the event of a sale where the startup wasn’t successful. By at least getting some capital back, angels are slightly more likely to invest in future deals and continue to put capital to work. With the fact that most startups fail, returning some money keeps capital in circulation helping the greater good.
What else? What are your thoughts on angel investors buying common or preferred stock?