The crowdfunding industry has employed various investment tools over the years. Some platforms suggest that founders offer specialized instruments like the CrowdSAFE, while others encourage them to sell regular stock. Syndicately’s approach is that everyday investors should have access to the same investment instruments as professional angels and venture capitalists. There are two main reasons for this:
Everyday investors should receive equal rights and protections as professionals and should not be at a disadvantage due to their lower bargaining power or level of expertise.
To prevent complications down the road, founders seeking investments from their communities should have straightforward terms that align with those of their other investors.
The frequent use of regular stock by some platforms poses particular challenges. Syndicately generally prohibits companies from raising funds with regular stock, except in exceptional cases. Institutional investors usually prefer preferred stock over regular stock due to the associated rights and privileges.
Advantages for Investors
One of the most significant benefits of preferred stock is the liquidation preference. This preference is crucial, especially for early-stage investments. Instead of the funds going to common stockholders (executives and employees), preferred stockholders are the first to receive their investment back. Common shareholders typically receive payments last. As Naval Ravikant, the CEO of AngelList, explains:
“The [liquidation] preference exists for a specific reason: Imagine my company is raising funds with a pre-money valuation of $9 million, and you invest $1 million, making the post-money valuation $10 million. Now, you own 10% of the company. If I decided to distribute the million dollars to all shareholders without a preference, I’d get $900,000, and you’d receive $100,000. That’s not what you expected. The preference is incredibly important in the early stages. It would be unwise to buy common stock in a seed round.”
Preferred stock also typically comes with other valuable privileges, such as anti-dilution rights to protect investments in case of a lower-priced financing round. When these rights are in place, investors receive additional shares for free, preventing a decrease in the value of their investment.
Additional benefits of preferred stock may include:
Pro rata rights, allowing investors to maintain their ownership stake as the startup grows.
The right to receive the first dividends.
Certain tax advantages, such as preferred dividends being taxed at the same rates as capital gains.
Advantages for Companies
Companies that offer preferred stock can experience several benefits:
First, they are more likely to attract investor interest due to the advantages mentioned above. If experienced angel investors expect to invest in preferred stock, founders offering common stock may struggle to secure capital from these investors.
Second, raising funds with preferred stock helps protect the value of employee stock options, which can be crucial for employee retention and recruitment. Employee stock options allow employees to purchase common stock at a predetermined price, typically based on the fair market value determined by an independent appraisal firm. When a company raises funds with preferred stock, the common stock’s value (and thus the exercise price of employee options) is often discounted, making it more affordable for employees. However, if the company raises funds with common stock, employees may need to pay significantly more to exercise their options, which can hinder employee retention and the attraction of top talent.
Companies seeking priced rounds should consider offering preferred stock to their investors. Retail investors, who are loyal supporters, customers, and early adopters, deserve the same protections as professional investors if the company faces difficulties. If the goal is to involve the community in the journey, they should not receive inferior terms compared to institutional investors. Additionally, offering common stock can negatively impact employees and, indirectly, the company itself.
It’s important to note that there are rare exceptions where common stock might be appropriate, such as for a successful late-stage company with a low risk of failure or a small business where existing professional investors hold common stock. However, for most cases, Syndicately will continue to uphold the requirement of preferred stock, ensuring fairness for both founders and investors.