The most basic and simple way of structuring a deal is to award common stock to an investor. Unfortunately, although there is beauty in simplicity, there is also a high level of risk. If a company goes under, the owners of common stock may end up getting little or none of their money back. This happens because creditors and owners of preferred stock (we’ll talk about that next) get first dibs on company assets in the event of liquidation. An additional downfall to common stocks is the fact that ownership is easily diluted when additional rounds of financing are executed. In spite of all this, however, the common stock remains a popular choice undoubtedly in part because of it’s simplicity. Truth be told, many people simply do not want to spend a lot of time on structuring a deal – and for those people, the common stock makes sense.
Preferred Convertible Stock
More desirable than common stock, the preferred convertible stock raises the priority of a shareholder above others in the company. In case of financial distress, any remaining money will be paid out to the owner of these shares before it is paid out to common stockholders. On the flip side, in the even of a home-run success by the business, preferred convertible shares can convert into common stock when the valuation is high. These abilities lower the risk of the stock, but can raise the intensity of negotiations between people involved in the investment process. Additionally, a near endless list of terms can be added to this structure that could spark tension with an entrepreneur. So while it creates a better scenario for the investor, the time spent during negotiations could be much more lengthy.
In conclusion, it’s important to understand how these two investment structures are only a couple of many investment types. There are a wide range of structures, each with different tradeoffs that can limit risk, maximize returns, and provide greater motivation and incentive to the investor and entrepreneur. In their book, Winning Angels, authors David Amis and Howard Stevenson admit that there are differing and contested viewpoints among angel investors regarding structure. Some investors place close attention to the structure of a deal, while others merely see it as something that can happen quickly so that other things can be focused on. No matter which camp you lean towards, however, having a knowledge of your options when investing in a new opportunity will always be worthwhile.
David Amis-Howard Stevenson (2001). Winning angels: the seven fundamentals of early-stage investing. Pearson Education.
Investopedia. What is Convertible Preferred Stock?