Startup companies come in a variety of shapes and sizes making the venture asset class a colorful form of investing. Learning the different investment structures and terminology will help you make informed choices about which startups to consider for investment.
There are several different investment structures that are used to invest in startups and early-stage companies.
Common shares are ordinary company shares most commonly held by founders and employees, although there are plenty of exceptions where early investors have also invested into the common shares. Common stock is the simplest form of equity. Common shareholders are generally granted voting rights, but can be limited and often have lesser rights than those granted to preferred shareholders. Most significantly, common shareholders can only claim their share of a company’s assets after the claims of debt holders and preferred equity holders (in that order) have been met.
Preferred equity is usually issued to outside investors and carries rights and conditions that are different from that of common stock. For example, preferred equity may include rights that prevent or minimize the effects of dilution or grants special privileges in situations when the company is sold.
A convertible note is a unique form of debt that converts into equity, usually in conjunction with a future financing round. The investor effectively loans money to a startup with the expectation they will receive equity in the company in the future at a discounted price per share to future investors. You can learn more about convertible notes here.
The simplest way to think about carried interest is as a performance fee. Carried interest is also called carry, promote or performance fee. In the world of venture capital and private equity, it is a share of the investor’s profit that is paid to the manager of a fund.
Carried interest in and of itself is not a bad thing – it incentivizes fund managers to put investors’ money to productive use and make sound investment decisions on their behalf (because if the fund doesn’t perform well, the manager doesn’t receive any carry). However, in the world of equity crowdfunding, carried interest can be a significant cost to the investor and one that misaligns platforms and investors.
Examples of Carried Interest
Two different types of carried interest:
Portfolio Carry: Let’s say you gave a fund manager $100K to invest, and that fund manager invested the $100K in ten different opportunities. If nine of those companies ended up failing and one was a home run which produced a 10X return on the amount invested, you would essentially end up where you started – with $100K returned (despite having invested $90K into failed companies). A simple return of your money which does not produce profits and would not generate any carried interest for the fund manager.
Per-Investment Carry: However, if you were to pay carry on an investment-by-investment basis – as is the case with many equity crowdfunding platforms – the math works out very differently. Assuming the exact same investments above, if you were to pay 20% carry on each of your investments, despite not generating any profit, you would still have to pay the full $20K in carry on the one successful investment, and would therefore end up with less money than you started with, or $80K returned (probably less after other fees and expenses).
How can this be? When carry is calculated on an individual investment basis, not across a whole portfolio, you would still be charged the carry of 20%, or $20k, on your one profitable investment. This is great for platforms and syndicate managers but bad for investors.
We do not charge carried interest to investors on SeedInvest.