One of the most critical – yet often overlooked – considerations for investors in private companies is where one falls within the overall “capital stack”. At its core, the capital stack is an overview of who has either invested in the company or lent the company money. This helps define which investors and/or lenders get paid back, in what order, and over what period of time. Put another way, the capital stack helps define which stakeholders have a preference over others.
When it comes to investing in private, early-stage companies, the order usually goes as follows:
- Debt Holders
This is relatively uncommon for companies seeking their first few rounds of funding since they typically don’t have the assets or track record required by traditional debt providers and are therefore viewed as too risky.
- Convertible Note Holders
Convertible notes represent a form of short- to medium-term debt that is designed to convert into equity. You can learn more about convertible notes here.
- Preferred Stock
Venture capitalists and angel investors purchase preferred stock in part to ensure they are repaid ahead of common stock holders.
- Common Stock
This class of stock is typically held by the company’s founders and employees.
SeedInvest will not allow fundraising companies to sell common stock to investors in our network. And while there are many reasons for this, two of the primary issues are that:
- Holders of common stock are paid out last in the case of a liquidation event like a sale of the company.
- Common stock does not include a liquidation preference, which helps protect investors in the case the company falls short of expectations.
While an in-depth discussion is outside the scope of this post, common stock lacks numerous rights, preferences, and protections early-stage investors should both expect and demand given the level of risk they are assuming. Regardless of what you may hear from a fundraising company or platform, there is virtually no instance in which an early-stage investor should feel comfortable or protected when purchasing common stock.
This post was written by aaronkellner on January 17, 2018