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Who Made More, Facebook VCs or Its Founder: The True Cost of the VC Preferred Stock Control Premium

Reggie Middleton's picture




 

So, I'm off to the races to raise money for UltraCoin, my uber-disruptive startup, and I come across the resistance of certain parties to take common stock. Now, the standard in the professional VC community is to take preferred stock with a stack of anti-dilutive measures, control premiums and liquidation preferences. VCs and their lawyers say this is the only way to do it because it protects them on the downside and allows them to maintain control of their investment and manage dilution on the upside. Basically, the say, it a hedge. I have some very prominent, very successful and experienced investors coming in doing the right thing. The reason is because they "get it". My task is to educate the rest. 

Marc Andreesen characterized VC start-up stock as an out-of-the-money call option on the success of the company. Well, I agree with this in part. The founders common stock is more like an OTC ATM call, or warrant, on the success of the company. The preferred stock, which is what most VCs go for, is more akin to a straddle consisting of an ATM long-dated OTC call paired with a long dated ATM put. This put is not free. It's not even cheap, and it is not as necessary if the deal is properly sourced and underwritten.

Now, I'm not the typical Fintech entrepreneur. I'm a little older than most, I'm probably better than forensic valuation than the vast majority (see Who is Reggie Middleton?), and I'm more than willing to point out when and where I think the establishment is doing something wrong. "Because everyone else is doing it" or "Because that's the way we've always done it" are not acceptable reasons.

Case in point, the preferred stock myth. Let's address the reasons given for demanding preferred stock.

  1. It protects them on the downside - This is true, but venture capital is a very high risk, high return asset class. Its much more additive to the risk/reward proposition to manage downside risk primarily through the investment selection and underwriting process, ex. spend your resources selecting and vetting the best management team and investment prospect rather than trying to manage downside before you even get a stab at the upside. Think about the groom that puts more time into the pre-nup than he does into finding out what his bride to be is actually about.  
  2. They say, it a hedge. Well, in the investment world hedges aren't free. They have a real cost and the determination of the effectiveness of any hedge has to take into consideration the cost of said hedge. If it's too expensive then the risks of the hedge may well outweigh the rewards. This is particularly true for investments that go well from a capital appreciation perspective.
  3. It allows them to maintain control of their investment and manage dilution on the upside and downside. The energies, time and resources dedicated to and consumed by the competition to gain and maintain control and proportionate share in a company materially detracts management from running the company as well as pitting multiple factions (equity holding management, common shareholders and founders, Series A, B, C [& X, Y and Z] shareholders and executives) against each other. If there was one uniform, common share class these factions could be fighting for the betterment of the company as a whole versus the betterment of their own individual positions (often to the detriment of fellow security holders and management and/or the company as a whole).  

These costs and detriments are real. Let's take the case of the very successful example of Facebook's VC funding and eventual IPO. Who do you think made more money in this deal, the founders/original common shareholders or the VCs who chose the preferred/hedged/put-call straddle route?

Just to make things interesting, I included one of the most prominent of Facebook's VCs in on the discussion via Twitter: 

The True Cost of the VC Control Premium  Here is the spreadsheet that generated the chart. Feel free to play with it yourself. Hopefully, more people will realized the value of going after a strong management team with a strong product amongst a disruptive opportunity. Focus more on the attainment of reward. Proper reward underwriting is its own risk management.

 

 

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Mon, 04/28/2014 - 15:39 | 4705072 I am a Man I am...
I am a Man I am Forty's picture

Hey Reggie!!!!  You still short apple?!?!  What do you have to say about the margin increase??  You've been bearish on apple from the 200's and claim you called the top.  Fooey!!!!

Wed, 04/23/2014 - 19:40 | 4688495 MeelionDollerBogus
MeelionDollerBogus's picture

LOL! "disruptive". No digital currency has been disruptive or likely is to be unless it's made by government & mandated by law.

Wed, 04/23/2014 - 13:14 | 4687053 slightlyskeptical
slightlyskeptical's picture

I think the real reason they demand preferred stock is that can gain control if management ends up flushing a viable biz down the toilet. Untradeable common stiock does not give them that ability.

Wed, 04/23/2014 - 15:53 | 4687720 Reggie Middleton
Reggie Middleton's picture

That chance of investors out managing a professional operator are slightly less than nil.  The due diligence for screening for competent want is during the sourcing of the deal,  not after the Investment is made.  Or should management try to control the investments of the VCs so they don't flush a viable LP contribution down the toilet. 

Wed, 04/23/2014 - 13:22 | 4687084 Bindar Dundat
Bindar Dundat's picture

Bang on Reggie -- common stock and one page shareholder agreements are all you need to build a business THAT WILL LAST FOREVER. 

I might even go one step further and put in a founders share that always votes 51% FOR AT LEAST TEN YEARS.

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