Investing in a startup? Make sure you get the right stock
One of my first startup investments was my most successful. Not because I made any money—in fact I lost the entire investment—but because I learned so much about what I should and shouldn’t do.
You see I had been investing in the stock market for years, so I knew what common stock was. In fact most everyone who invests in the stock market invests in common stock. It’s actually very simple to do. You call your broker or go online and buy some stock, hoping that it goes up in value so that you can sell it later and make a profit. You don’t worry about other investors coming in later, buying stock and diluting your ownership. In fact you want other investors to come in, as the more demand there is for the stock the more it increases in value.
But in startup investing, or angel investing, it’s not that simple. Of course you still buy stock and hope it goes up in value so you can make a profit, and you hope more people come in and want to buy the stock. But this isn’t a company that has already gone public with a finite amount of shares available to buy and sell. In a startup every subsequent fundraising round means more stock. It’s like a pie that is growing in size. If you already have your piece, your percentage of ownership goes down as the pie grows unless you can acquire more of the pie. In a startup, the new investors are buying new stock, and unless they’re paying a lot more than you did, or you buy more shares to maintain your percentage of ownership, your investment is actually going to decrease in value.
I bought common stock. When the venture capitalists (VC) came in a subsequent round they got preferred stock. More than that, they received rights associated with that preferred stock. Terms like ‘anti-dilution protection’, ‘follow on rights’, ‘rights’, and ‘warrants’ were foreign to me. Terms or results like ‘cram down’ or ‘haircut’ as it applied to investing were completely unfamiliar. I was about to learn them in a very painful way, however.
My investment was in common stock and it came with no voting rights or protections. Based on my investment I owned a nice piece of the company, but as additional shares were issued that percentage of ownership went down.
The next fund raising round wasn’t offered to the angel investors with common stock. Instead a venture capital fund came in and took the entire round. That could have been a good thing if they came in at a higher valuation and if I could have come in with them. Instead they did a cram down, lowering the valuation by half. So now my stock was worth half of what I’d paid. As if that weren’t enough, the company issued new preferred stock to the VC, increasing the size of the pie and reducing my percentage of ownership. They also received warrants with their purchase which would give them more stock later at a greatly reduced price. That meant more dilution for me. They also made sure to get additional rights like follow on rights so that during the next funding round they could participate even if a different VC fund took the round. They also made sure to get anti-dilution protection so that if the next round was at a lower valuation for the company they would be issued more stock at no cost to them to maintain their percentage of ownership. With these protections they avoided the haircut I had taken.
As I said, these terms were all new to me but I learned them quickly. I also realized that I was in over my head when it came to early stage investing. I figured I wasn’t the only one that this had happened to, so I decided to go to the web and start searching for information and help. I found a number of forums on angel investing and a few local groups that met to discuss the subject and even invited startup companies to come in and present.
I started going to these groups and reading everything I could on the subject. I learned how to vet companies and how to negotiate terms, and I never made an investment again without making sure to get the proper stock and protections.
The most important thing I learned from my experience is to do my homework. It’s very easy to get excited about a promising new company or technology. It’s easy to imagine the money you might make if the company hits it big, but it won’t matter how big the company hits it if the stock you invested in gets diluted down to zero when the subsequent fundraising rounds come and you take the haircut.
George A. Santino is a professional speaker, mentor to tech managers and author of Get Back Up: From the Streets to Microsoft Suites, scheduled to be released June 2016. Connect with George on www.GeorgeASantino.com and on Twitter, @georgeasantino.