Structuring – Early Stage Investing Series

In our previous installment we looked at how an angel investor might value an opportunity. We now come to the next stage in early investing, and that is structuring. Once the value of a deal is agreed upon, the terms and conditions must be decided. But it’s not always as easy as we might think. Equity percentages can become diluted with further rounds of financing, and high hopes for success can sometimes crash and burn leaving the investor without an escape. There is hope, though. Rest assured, the structure of a deal can help insulate an investor from various degrees of loss (although it can never protect from total loss). For the purposes of this article, we will briefly examine a couple of the ways that an investment can be structured.

Common Stock

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.


Sources:

David Amis-Howard Stevenson (2001). Winning angels: the seven fundamentals of early-stage investing. Pearson Education.

Investopedia. What is Convertible Preferred Stock?

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6 thoughts on “Structuring – Early Stage Investing Series

  1. Hello Austin great post! It is definitely a risk when it comes to the common stock in a company and to some level the preferred stock is a little more secure. Their is a risk in any investment. I invest in the stock market, fortunately I haven’t lost what I put in. However I have lost money, and what I mean by that is my initial money I invested is still secure , but I have gained and lost a generous amount of money. As I teach my son to invest I always express that he needs to look at the past markets and research, research, and research. I would advise the same even when investing in a company to take the time as an investor to do the research on all aspects of the person presenting the company, the market,etc., so that you can make the best structured deal.

  2. Austin,
    Great post! I agree, either of the two come with its own set of challenges but the preferred stock seems to be more reliable. I use the term reliable kind of loosely because nothing is guaranteed it just provides and additional way to not lose in the overall investment.

  3. Austin,
    This information really gave me a little more clarity – I was explaining to one of our team – members that I am on the fence about common stock- because it seem so tricky; however, after reading the book and differ post; it boils down to researching, researching and researching and decided which method will be effective your business. However, I still do not believe that common stock would be a option for me- but, I will still consider it.
    Thanks for sharing !

  4. Austin,

    Great article! You gave some valuable information and reasoning behind each decision. Common stock (hence the name) is probably the easiest for a simple no hard work effort approach. But, after reading your description, it sounds kind of scary – unstable if something were to happen to the business/company. If it were me, I would probably go with the second option, preferred stock. You would get some type of “refund” if something happened to the company.

    Thanks for this great post!

    Christina

  5. Position and alignment in a deal is key to ROI. The greater your dollar power can position an investor for the first round of pay backs. As an investor we should always want a drivers seat instead of rider on the third row. The ones who sit farthest back have less influence. Think of an SUV, who sits on the third row (kids or people with short legs). The preferred stock should be the first choice when investing.

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