Aligning Incentives: Preferred vs Common Stock

An investor friend of mine posted on his blog this question:

This week’s sign of tech bubble: multiple seed-stage startups demanding investors buy common stock instead of preferred. Thoughts? I have strong professional opinions on this and will draft a full blog post on the topic, but thought I’d crowdsource some input first…

Every start-up business that is looking for external funding has three basic outcomes:

1. The business becomes wildly successful and is bought or goes public at a valuation that is many multiples of its original value.
2. The business runs out of cash and must be sold in a fire sale/bankruptcy
3. The business barely reaches a positive cash flow allowing it to stay in business indefinitely, but without much prospect for growth. I’ve heard this affectionately called “the walking dead” by several investors.

Investors are motivated to put their money to work. By putting their money in the hands of skilled entrepreneurs that can turn that money into more money. entrepreneurs are interested in building a successful business AND turning their time into more money. When investors and entrepreneurs partner together, the goal is to align motivations across the three various outcomes.

Preferred stock gives the investor certain additional ‘preferences’. These typically cover cases #2 or #3 in the above scenarios. For example, if an investor puts in $1M for 30% of the company and the company sells in a fire sale for $2M, the investor has the right to get his $1M back first instead of the $600K that he would receive as his pro-rata share. Better explanations of the variants on this can be found over at AVC.

The primary motivation behind preferred stock is to protect the investor in the case of an unsuccessful outcome. The reasoning typically given goes something like: employees used the money of the company to get paid their salary but were not successful in turning the business into a profitable entity, therefore the investors should be entitled to their money back in the case of fire-sale.

There are four possible flaws to this argument:

1. The argument ignores that employees are also investing their time in the enterprise. This time could be spent in other endeavors. Typical startup salaries are less than in a large enterprise, so the employee is also investing the difference in his earning potential (the difference between the money he will make, and the money he would have made elsewhere).
2. It assumes the entire responsibility for the business succeeding or failing depends on the work of the employees. Since it’s possible for unforeseen issues that are out of the control of employees to take a business down, they should not carry the full weight of that outcome.
3. It assumes the employees need investors to build the business. If investors are having a hard time finding opportunities to put their money to work, or the opportunity is so strong that the risk of outcome #2 and #3 is low enough, it doesn’t make sense to add the complexity that comes with different kinds of stock.
4. It assumes that VC’s will make judicious use of their preferences (or more accurately, are focused on aligning motivations as partners not trying to secure an aggressor/victim relationship)

In the end, the question is about negotiating incentives that cause everyone to focus on outcome #1 as the ideal while still mitigating risk for all parties in the outcomes #2 and #3.

In the case of argument #1, the problem here is whether or not the salary being paid to the employee is greater than other opportunities might provide. If that is the case, then there is a strong motivation for them to make this into a lifestyle company (outcome #3) rather than taking the risks that are needed to result in outcome #1. If the salary is significantly less than other places, then the employees are also motivated to outcome #1. (I would expect to see this kind of structure in any “everyone owns common stock” deal).

I could see entrepreneurs wanting to make argument #2 but I don’t think it’s a very strong argument for aligning motivations. If you couple this argument with an overemphasis on “fail early, fail often”, it likely leads to far more #2 outcomes, where the employees would still reap some reward for their failure.

The third argument is probably the most indicative of a tech bubble. If investors can’t find enough qualified places to put their money, then entrepreneurs can select their pick. It is obviously in their interest to own the same kind of stock as the investors. Ultimately, it is becoming easier and easier to start companies without additional capital (especially at the seed stages).

The fourth argument is probably the reason this is getting requested. Similar to the point I made on the challenge of pricing , because VC’s have a reputation of abusing entrepreneurs that don’t know better, they are now reaping the reward of this reputation. Namely, that the entrepreneurs don’t want to trust that VC’s will make judicious use of their preferences.

When you couple the reduced need for external capital with the abuses of VC’s, I can see why entrepreneurs are looking to change the motivation calculus at the onset.