{"id":84362,"date":"2025-02-12T18:17:06","date_gmt":"2025-02-12T18:17:06","guid":{"rendered":"https:\/\/peraltafinancing.com\/angel-investor\/why-investors-dont-want-common-shares-pitching-angels\/"},"modified":"2025-02-12T18:17:06","modified_gmt":"2025-02-12T18:17:06","slug":"why-investors-dont-want-common-shares-pitching-angels","status":"publish","type":"post","link":"https:\/\/fivemor.com\/?p=84362","title":{"rendered":"Why Investors Don\u2019t Want Common Shares \u2013 Pitching Angels"},"content":{"rendered":"


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Venture\u00a0investors require preferred stock instead of common shares<\/h2>\n

Imagine you raised $2M in your startup at a $20M valuation. Investors now\u00a0own 10% of the business. You, the founder, hold 90%.<\/p>\n

But after a year, all is not well. You want to pivot to a completely different business. The investors demand you stay the course. They have a seat on the board.\u00a0Meetings become acrimonious. They even ask you to find a new CEO.<\/p>\n

So you and your lawyer come up with a devious solution. You\u2019ll sell the business to yourself for $1.<\/p>\n

You sign the paperwork, duly deposit a dollar in the company account and voila! you now own 100% of the business. Bye-bye investors, it was nice knowing you.<\/p>\n

Fair? Of course not. Legal? Probably.<\/p>\n

Investors can try to argue the transaction was fraudulent, but that won\u2019t be easy. A lawsuit will probably cost more than the investment, and for what? The best we can do is claw back the shell of a business without employees or customers. There\u2019s really no choice but to write it off as a loss.<\/p>\n

There are a million similar scenarios: the startup taking $1M in investment, then paying the founder a million dollar bonus; millions of shares sold to the founder\u2019s family for a penny each; a successful business paying the founders huge salaries instead of distributing dividends to investors; the founder agreeing to an acquisition where he gets a lucrative new job but shareholders get nothing.<\/p>\n

Public companies usually can\u2019t get away with these kinds of shenanigans. Most of the stock of public companies is owned by independent shareholders, and there\u2019s enough money at stake to fight any self-dealing by executives and majority shareholders in court.<\/p>\n

But in the startup world, the founders usually hold the majority of the stock and control the board. Our incentives are not always aligned.<\/p>\n

The solution: preferred shares.<\/p>\n

What are Preferred Shares?<\/h3>\n

Preferred shares are essentially the same as regular common shares with a few critical differences.<\/p>\n

First, and foremost, preferred shares get\u00a0separate voting rights<\/em><\/strong>\u00a0for key corporate changes such as acquisitions and issuing new shares. That means\u00a050% of the preferred shareholders will need to approve any changes, essentially giving investors veto rights.<\/p>\n

Another important difference is a\u00a0liquidation preference<\/em><\/strong>. This guarantees\u00a0investors get our money back prior to common shareholders getting a payout; i.e., if we invest $2 million at a $20M valuation (10% ownership), but the company is sold for only $5M, instead of getting only a $500K payout, preferred shareholders get our full $2M investment returned before the remaining $3M is distributed.\u00a0(A separate article on liquidation preferences\u00a0here<\/a>.)<\/p>\n

Preferred shares often include other rights important to minority investors, such as:<\/p>\n