Investing in equity means that you invest your money in exchange for the company’s stocks, or equity ownership in the company.
While novice investors may agree to buy common stocks, experienced investors almost always request preferred stocks. There are exceptions, of course, as discussed in this short, three-part series.
Before 2000, angel investing was relatively new, and established best practices were lacking. Hence, angels mostly purchased common stock. [1]
Image by: GDS Infographics
However, as angels learned from their mistakes and gained a sharper understanding of the industry after the dot-com bubble, they began to adopt best practices from the venture capital (VC) community and started doing preferred stock deals.
Since then, the angel world has split in the past decade, with experienced investors doing almost exclusively preferred stock deals, and “naive, friends and family angels” investing in common stocks and straight convertible notes. “Virtually no outside investors do common stock deals [nowadays],” says one angel.
Sidenote: Some seasoned angels are willing to do convertible debt deals as long as the notes come with a price cap. Convertible notes is a big topic on its own, and you can learn more about using convertible notes as a pre-Series A deal structure in a special report called “Startup Investing: What You Need to Know About Convertible Notes.” This brief focuses on common and preferred stocks.
Common shares are cleanly and simply structured. Founders, employees and friends and family investors typically hold this type of equity.
So unless they’re dying to get into a deal, sophisticated angels rarely purchase common stocks, as this type of equity offers investors little protection.
Unlike friends and family investors, professional angels don’t invest due to their warm, fuzzy feelings toward entrepreneurs; also, they invest hard cash as opposed to the founders’ and employees’ sweat equity. Thus, experienced investors want to protect themselves with rights that rank ahead of common shareholders.
This is where preferred shares come in. This type of equity includes a list of unique rights that protect investors’ downsides. Holders of preferred shares are entitled to preferential treatments over holders of common shares.
Among the special rights, the most important one, which differentiates between common and preferred shares, is called “liquidation preference,” a feature that entitles preferred shareholders to get paid in full first in a liquidity event (e.g., a sale, IPO, or shutdown); common shareholders receive the remaining proceeds. The payment to preferred shareholders is typically a multiple, for example, 1x or 2x, of what they originally paid for their stocks.
* For series, references are published in the last installment of the series.
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