5 Years of Startup Stock Investing: Lessons Learned

Pillar VC's Approach to Startup Investment: Common Stock Focus

Since its inception, Pillar VC has consistently offered to acquire common stock within the startups it invests in.

This deviates from the conventional venture capital practice of utilizing extensive, multi-page term sheets filled with numerous stipulations.

Instead, the Pillar VC team posited that a more streamlined structure—one where they held the same class of security as the founders—would foster greater alignment of interests.

The Rationale Behind Common Stock Acquisition

The core belief was that this approach would cultivate increased trust and, ultimately, improve the overall performance of their investment portfolio.

By sharing the same equity class, Pillar VC aimed to create a more collaborative and mutually beneficial relationship with the startups they backed.

Reflecting on Five Years of Common Stock Investments

Having now completed the investment phase of its second fund and initiating the deployment of its third, Pillar VC undertook a review of its strategy.

This assessment focused on determining whether the decision to prioritize common stock over preferred stock had yielded the anticipated advantages.

The analysis sought to validate the initial hypothesis regarding alignment, trust, and investment outcomes.

Key Benefits of the Approach

• Alignment of Interests: Sharing the same security as founders encourages a unified vision for the company's success.
• Increased Trust: A simpler structure can build stronger relationships based on mutual respect.
• Enhanced Performance: Aligned incentives are expected to drive better results for all stakeholders.

The firm’s experience over the past five years provides valuable insights into the effectiveness of this unconventional investment model.

Misaligned Incentives in Preferred Stock Arrangements

Numerous stipulations within a preferred term sheet can create discrepancies in the interests of investors and founders. For the sake of conciseness, only two key areas will be examined here. (A more comprehensive analysis can be found using a term-sheet grader).

Preference Rights

Preference in preferred stock grants the investor the option to receive a return of their initial investment or to accept their proportional share of the total proceeds from a sale. In unfavorable scenarios, this can result in the investor claiming a significantly larger portion of the proceeds than originally anticipated by the founders.

Consider a scenario where an investor acquires 25% of a company for $2 million in preferred stock. The threshold for this decision is a post-money valuation of $8 million. Should the company be sold for less than $8 million, the investor would opt to reclaim their $2 million investment.

The founders believe they have relinquished 25% ownership, but this percentage is contingent upon the final sale price. If the company sells for $8 million or more, the 25% allocation holds true. However, a sale at $4 million would see the investors taking back their $2 million, representing 50% of the proceeds. A sale for only $2 million would result in the investors receiving the entirety of the funds.

Anti-Dilution Provisions

Anti-dilution clauses stipulate that if an investor purchases shares at a specific price (e.g., $10) and the startup subsequently raises capital at a lower price, the investor’s share price will be adjusted retroactively. This adjustment is typically achieved by issuing additional shares to the investor.

This issuance dilutes the ownership stakes of all other shareholders, particularly the founders and employees. Essentially, the investors are protected from the effects of a declining company valuation, with the cost borne by those who built the company. This is hardly a scenario that fosters alignment.

In reality, the benefits of preferred stock features have limited impact on returns for seed-stage investors. For substantial successes – the primary source of returns in venture capital – these features become irrelevant as all invested capital is converted into common stock.

Conversely, when a startup underperforms or fails, preferred terms rarely matter due to the lack of available proceeds. We adopted a different approach, prioritizing the creation of an optimal environment for achieving significant outcomes.

This meant foregoing the pursuit of “cents on the dollar” in underperforming companies through aggressive preferred term negotiations. We consciously traded potential downside protection for the opportunity to maximize upside potential.

The Positive Outcomes of Utilizing Common Stock

Our initial motivation for acquiring common stock was to cultivate a stronger sense of trust with founders. The objective wasn't to gain a competitive edge through marketing or securing individual deals.

Instead, it stemmed from a genuine commitment to ethical practice and shared objectives. After five years of implementation, we firmly believe that this approach has demonstrably shown founders our dedication to their success.

Enhanced Trust and Decision-Making

This, in turn, has fostered deeper trust and facilitated more efficient, quicker decision-making processes. Founders feel more confident when they perceive genuine alignment with their investors.

We understand that increased trust alone may not be sufficient justification for all investors. Therefore, consider this point: Pillar’s most successful investments originated from deals structured with common stock participation.

Attracting Founders Seeking Alignment

Many founders actively sought investment partners who eschewed traditional venture capital structures. They specifically chose Pillar because our willingness to invest via common stock clearly illustrated our commitment to alignment.

In numerous instances, founders who were hesitant about conventional VC terms opted for Pillar specifically due to this demonstration of our principles – we proved we were committed to “walking the talk.”

This approach has proven invaluable in attracting founders who prioritize a long-term, collaborative partnership over short-term gains.

Insights Gained from Common Stock Investments

Throughout our investment journey, several observations have emerged, alongside obstacles that demanded solutions. This experience has broadened our understanding of the dynamics at play.

Initially, we encountered a surprising preference among some founders for us to acquire preferred stock rather than common stock. This occurred on several occasions during our first two years of operation. The rationale? These founders were dissuaded by other investors – those they sought to involve in the investment group – or, unexpectedly, by their own legal representatives.

What motivates company legal counsel to recommend the “standard deal,” even when a more advantageous option exists? Primarily, it stems from a lack of familiarity and a reluctance to embrace the unfamiliar. A common initial response from legal teams is the concern that investor purchases of common stock will disrupt the pricing of the employee stock option plan.

However, a brief investigation reveals this concern to be unfounded. 409A valuation firms are well-equipped to manage option pricing in such scenarios, and the resulting discount remains substantial compared to the price paid by investors. We have successfully implemented this approach numerous times without encountering any issues.

A further, less obvious consideration involves voting thresholds. As a company evolves and attracts new investment, negotiations often center on the percentage of investor shares required to approve significant corporate actions. This is frequently discussed in terms of fractions, such as “2 out of 3” or “3 out of 5” investors, but is formally defined as a precise percentage.

For instance, 64% might represent the investor shareholding needed to authorize a new funding round. Should our common stock holdings be factored into this calculation? This is generally not a point of contention between us and the company; the company usually favors our inclusion, recognizing our alignment with their interests.

However, occasionally, newer investors may seek greater control over these decisions. Regarding voting thresholds, we collaborate with founders and subsequent investors to establish a framework that is both sensible and supportive of the founders’ objectives in future investment rounds.

Ultimately, while we have been prepared to exchange downside protection for potential gains, we have not yet experienced a situation where an investment in preferred stock would have yielded a better outcome than an investment in common stock. This situation may arise in the future, but to date, acquiring common stock has consistently proven beneficial for us.