You may have noticed that a majority of the deals on equity crowdfunding platforms such as StartEngine and Wefunder offer common stock to investors. Common stock is what’s typically traded on the major stock exchanges, so it’s probably standard to purchase in the private markets too, right? Wrong. In fact, common stock offerings in the private markets are a relatively recent occurrence tied to platforms allowing companies to take advantage of investors who are new to early stage investing.

 

What’s wrong with purchasing common stock?

Common stock is the simplest form of equity, intended to be held by a company’s founders, employees, and advisors (i.e., the insiders of the company). Generally speaking, common stock lacks numerous rights, preferences, and protections that early-stage investors should not only expect, but demand, given the level of risk they are assuming.

There are three glaring issues when it comes to common stock:

  1. Common stock typically lacks standard protective provisions, which are intended to prevent companies from taking actions that would negatively impact their investors without first receiving investor consent. Granted, platforms such as StartEngine & Wefunder actually encourage companies to issue common stock stripped of even basic voting rights, but that’s another topic altogether…
  2. Common stock falls last in the capital stack. This means that the holders of common stock are paid out last in the case of a liquidation event, like the sale of a company.
  3. Common stock typically does not include a liquidation preference, pro-rata rights, or anti-dilution protection (more on these below) which all help protect investors should a company fall short of expectations, as well as provide more economic upside should things go well.

Historically, SeedInvest has not permitted companies that are fundraising on our platform to sell common stock and will not allow this except for very specific situations (e.g. the company is planning to immediately list on an exchange following the SeedInvest financing).[1] Other platforms are replete with companies that were rejected by us due to their desire to take money from investors without granting them the basic rights and protections we believe every early-stage investor deserves.

 

If not common stock, what type of securities can be found on SeedInvest?

Companies raising on SeedInvest will typically offer preferred equity or convertible notes that convert into preferred equity. [1]

Those that are new to investing in venture capital typically have misconceptions about preferred equity, especially those whose investing experience is derived from investing in the more traditional public markets where preferred equity has very different connotations (a debt instrument that accrues dividends while not participating in any upside of the underlying company).

In the context of early-stage investing, preferred equity is the type of security that is typically issued to investors outside of the company. This class of securities grants special rights and privileges that work to provide greater protection and avenues of greater influence on company decision making. Some of these can include: 

  1. Anti-Dilution Rights: an investor’s right to offset the dilutive effects of a potential down round.
  2. Pro-Rata Rights: an investor’s right to participate in subsequent rounds of financing to maintain their level of percentage ownership in the company.
  3. Liquidation Preference: an investor’s right to get his or her money back before the holders of common stock, which as mentioned above, typically include company founders and employees and is purposefully designed to align interests between a company’s founders and its investors.
  4. Protective Provisions: an investor’s right to vote on potential corporate actions that may negatively impact his or her investment (e.g. authorization of a new class of stock, dissolution or sale of the company, adding or changing members of the Board, etc.).

 

The Bottom Line.

Investors cannot benefit from the venture capital asset class if they don’t invest like venture capitalists. As an investor, it does not make sense to invest in companies with terms that an experienced investor would turn down, such as purchasing common stock or any other security type that does not offer the rights and protections that you should receive when taking the risk of investing in an early-stage company (see examples from our liquidation preference blog post). VC funds don’t do it, and neither should you.

 

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[1] SeedInvest’s selection criteria does not suggest higher quality investment opportunities nor does it imply that investors will generate positive returns in investment opportunities on SeedInvest. Learn more about due diligence in the SeedInvest Academy (/academy/how-to-assess-a-startup-investment)”and our vetting process in our FAQs (/faqs)

This post was written by Jonathan Casterline on March 10, 2021

Investor Education Series: Beware of Common Stock


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