This is the second installment in our multi-part series on startup investing. If you haven’t read Part I on why you should consider adding the venture capital asset class to your overall portfolio, you can do so here. Part III can be found by clicking here: Part III – Diversification and the Potential for Outsized Returns.
During Part I we learned that venture capital returns have not been highly correlated with the returns generated by public stocks historically and because of that venture capital can actually help you diversify and de-risk your overall portfolio. The question now becomes: how should you go about investing?
Invest Like a VC
It’s fairly common knowledge that fundraising is hard. It also makes sense to learn that the majority of early-stage companies never receive VC funding. What may be surprising to learn is just how few companies receive funding from a VC or otherwise. Data suggests that less than 3% of U.S. companies obtain startup financing in any form. This suggests that VCs and others that invest regularly in the asset class are very picky when reviewing investment opportunities. And you should be too.
Didn’t You Just Say That Asset Allocation Matters More Than Stock Picking?
Yes, that is still true. But asset allocation does not mean blindly investing in every opportunity that comes your way. In order to approach VC-like returns, you must take into account all of the variables a VC does, which involves due diligence and setting aside investments that don’t provide an appropriate risk-reward profile.
Early-stage venture capital represents a potentially attractive asset class, having returned 22.65% compared to 9.93% for the S&P 500 over the last 30 years.,, But there is no reason to believe you’ll have the potential to earn these types of returns if you skip due diligence or invest in everything that comes your way.
Terms Drive Returns. They Matter… A LOT
Even if you invest in the same company as a VC, the only way to generate the same return is by investing on the same terms. You shouldn’t settle for terms that significantly alter your return profile, especially if other investors receive better terms at or around the same time you are investing.
Let’s take Preferred Equity as one quick example. There are numerous misconceptions about preferred equity among most who are new to venture capital, especially those whose investing experience is primarily drawn from the public markets. Common stock is what’s traded on the exchanges so that’s what I should own as well, right? Wrong.
VCs almost always invest by purchasing preferred equity versus common stock. Why is this the case? In the world of private company investing, the connotations associated with preferred stock in the public markets are not applicable. In this world, preferred stock guarantees that if there is a pay out, the preferred stockholder will get paid before the common stockholder (i.e. they quite literally have “preference”). If things don’t go according to plan, being a preferred stockholder can mean the difference between getting your money back and not. Please see Exhibit A for a more detailed description and walkthrough of why this is the case.
Preferred equity also typically comes with additional investor rights and protections that you do not receive as a common stockholder and which can also significantly alter potential return profiles. To be clear though, preferred stockholders generally don’t have a preference over traditional debt or convertible notes (another form of short-term debt), so don’t forget to check whether a company has outstanding debt obligations.
Bottom line: as an investor it makes no sense to invest in startups if the terms at which you’re doing so are off-market or are terms that experienced investors would turn down, such as buying common stock or securities which can artificially cap your returns. The risks are simply too great.
This Is a Lot to Keep in Mind
There are seemingly countless factors to consider when evaluating startups. SeedInvest endeavors to bring transparency and simplicity to what has historically been an opaque and complicated process. The SeedInvest team is comprised of former professional investors who helped manage billions of dollars in private investment funds. We conduct independent, multitiered due diligence on every offering before allowing companies to list on our platform.,  Unlike other platforms, our goal is to not simply provide a streamlined investing and fundraising experience for the investors and entrepreneurs with whom we work, but also to help ensure investors in our network are treated fairly based on the level of risk they are assuming.
Exhibit A 
Let’s walk through a hypothetical example to see how a Liquidation Preference can affect your return.
To begin, let’s assume a startup is raising a $250,000 Seed round (the first money that it has raised) at a $1,000,000 “pre-money valuation” (i.e. pre-fundraise valuation) through the issuance of preferred stock and does not have – or will have – any outstanding debt or later investors who also receive liquidation preferences. Assuming exactly $250,000 is raised, the Seed investors would own 20% of the company ($250,000 / $1,250,000). The $1,250,000 figure is known as the “post-money valuation” (i.e. how much the startup is worth immediately post- fundraise).
Holding all else equal, let’s see what happens in each of the following scenarios:
- No liquidation preference (i.e. common stock)
- 1.0X liquidation preference (market standard)
- 1.5X liquidation preference
- 2.0X liquidation preference
A liquidation preference represents an investor’s right to get his or her money back before common stockholders get paid back and is typically expressed as a multiple of the initial investment.
Based on the above example then, if the liquidation preference is 2.0X, Seed investors are guaranteed 2.0X times their money back assuming the startup returns at least $500,000 to its shareholders (i.e. 2.0X the $250,000 Seed round size).
How do our Seed investors make out if the startup doesn’t raise any more money, does well, and gets acquired at a $3M valuation? In this case, quite well. Seed investors would be taking home $600,000, a 2.4X return.
How about if the startup didn’t do as well? Let’s say it got acquired for only $2M. In this case, here’s how much Seed investors would take home assuming a few potential liquidation preference multiples.
Seed investors would still earn a 2.0X return only if their preferred stock included a 2.0X liquidation preference. In every other scenario, they would only earn a 1.6X return.
Where liquidation preferences really matter though is the scenario in which the startup does poorly. Let’s say they got acquired for only $1M. Recall the post-money valuation (what the company was worth immediately after their fundraising) was $1.25M, so in this case the startup dropped in value.
In this scenario, if Seed investors didn’t receive a liquidation preference (which would be the case if they had invested in common stock) they would receive 80 cents on the dollar. If they had simply invested through preferred stock and received the industry-standard 1.0X liquidation preference they would have gotten every dollar back.
Taking it one step further, if the investors had received 1.5X or 2.0X liquidation preference, they would have actually earned 1.5x and 2.0x return, respectively, despite the startup losing value.
Here is a graph depicting Seed investor returns across these scenarios:
Although just one of many, liquidation preferences represent one of the major (and often overlooked) terms that can significantly impact your overall returns. Investors should always pay attention to such terms and conduct due diligence on both the company and how the investment is structured before investing.
This post was written by aaronkellner on August 9, 2019
Due Diligence and Why Vetting Matters – Part II