What I’ve learned after 5 years of buying common stock in startups

From day one, Pillar VC has offered to buy common stock in startups.

Instead of the standard 10-page venture capital term sheet riddled with terms and conditions, our team believed that a far simpler structure where we owned the same security as the founders would align interests, increase trust, and hopefully, enhance the performance of our investments.

Five years since launching Pillar, as we finish investing our second fund and begin deploying our third, we thought it was a good time to reflect on whether buying common stock instead of preferred stock has offered the benefits that we had hoped for.

Preferred stock can misalign incentives between parties

There are many terms and conditions in a preferred term sheet that can misalign investors and founders — for brevity, I’ll highlight just two below. (For more, see the term-sheet grader).

Preference: Preferred stock has a “preference” that gives the investor the right to choose whether they want to get their money back or take their percentage of the total proceeds. In downside scenarios, having an investor take their money back may mean that they are taking a far higher percentage of the proceeds than the founders “thought” they sold.

For example, if an investor buys 25% of a company for $2 million in preferred stock, their break point on this decision will be $8 million, which happens to be the post-money valuation of the round. If the company is sold for less than $8 million, the investor would rather take their $2 million back. If the company is sold for more than that, the investor would choose to take 25% of the total.

The founder thinks that they sold 25% of their company, but that percentage is actually determined by what the company is sold for. Yes, if the company is sold for $8 million or more, they sold 25%, but if the company is sold for, say $4 million, the investors will choose to take their $2 million back, which is 50% of the proceeds. Worse still, if the company is sold for just $2 million, investors will take all of it.

Anti-dilution: This clause means that if an investor buys shares for $10 and the startup raises money in the future at a price point that is lower than $10, the investor’s share price will be recalculated retroactively to a lower price. How is this done? By issuing the investors more shares, which dilutes the rest of the ownership pie, especially the founders and employees. The company is not performing well and the investors are made whole at the expense of the founders. Aligned? Hardly.

When it comes to making money as a seed-stage investor, the features of preferred stock have little positive impact in practice. For big wins — the primary drivers of returns in the VC industry — these preferred stock features all wash away, as all invested capital is converted to common stock. When a startup underperforms or fails, preferred terms rarely matter, because there’s little or no pie to divide anyway.

We chose a different strategy: Focusing on creating the best possible environment to build big outcomes, and forgetting about the “cents on the dollar” we could get back in poorer-performing companies if we had negotiated preferred terms. We traded downside protection for upside enhancement.

Across our first two funds of $57 million and $100 million, Pillar has invested in 45 companies.  For the rounds we led, we let the founders choose whether they want us to buy common or preferred stock. We bought common stock in 11 companies. Petri Bio (Pillar’s biotech accelerator) has invested in 11 companies, and holds common stock in all of them. All told, we hold common stock in 22 of 56 companies, 38% of the total.

Successes of the common stock approach

Deeper trust was our goal when we first thought of buying common stock. It wasn’t about winning the incremental deal or somehow “out-marketing” our competitors. It was a desire to be good and to be aligned. After five years, we are convinced that buying common stock has helped founders see that we are on their side, which has resulted in deeper trust and better, faster decision-making.

Still, we recognize that deeper trust might not be a convincing enough benefit for some investors. Perhaps this fact can serve instead: Pillar’s most valuable investments are deals our team did as common stock.

We’ve made numerous investments where either the founders were not interested in VC if it came with the usual “trimmings,” or they chose Pillar, regardless of structure, because our willingness to buy common stock demonstrated that we “walked the talk” on alignment.

Learning from common stock investments

As with any experiment, we have learned a few things that have surprised us and faced challenges we’ve had to overcome.

First, we’ve been surprised that some founders choose to have us buy preferred stock instead of common. This happened a few times in our first two years. Why? Because these founders were talked out of it by other investors (who they wanted to include in the syndicate) or, ironically, by their own legal counsel.

Why would company counsel advise founders to take the “standard deal”” rather than something that would clearly be better? Mostly because they have no experience with it and fear the unknown. For example, the very quick answer you’ll get from counsel is that having investors buy common stock will screw up the pricing of their employee stock option plan. If they merely invested a few minutes to understand, they would realize it does not. 409A valuation firms know how to handle option pricing in these situations and it is still a significant discount to what investors paid. We have done this many times with no issue.

Another more subtle topic is voting thresholds. As a company matures and new investors are added, investors will often negotiate the voting threshold required to approve important corporation actions. This typically is discussed as “2 out of 3” or “3 out of 5” investors, but is documented as a carefully calculated percentage. For example, 64% can be the number of investor shares required to approve a new financing.

Should our common “investor” shares be included in this calculation? This is not an issue between us and the company — the company typically wants us to be included because they know we are the ones most likely to be aligned with them. But sometimes new investors prefer to have more control over these decisions. When it comes to voting thresholds, we work with founders and follow-on investors to craft a structure that makes sense and is founder-aligned in the follow-on round.

Finally, while we’ve been prepared to trade downside protection for upside enhancement, we’ve yet to see the downside materialize in a way where our investment in preferred stock would have been better than an investment in common stock. That time may come, but so far, buying common stock has only had upside for us.

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