Why do most venture capitalists receive preferred company stock?

This has evolved over time.

In the Old Days, preferred stock had two key advantages:

  • They had some downside protection, in that they’d be paid first in the case of a small exit; and
  • They had upside “protection”, in that participating preferred increased the return of preferred over common, often until a significant cap (say a 500% return).

But times have changed.

First, almost all acquirers in smaller deals rewrite the acquisition terms in some fashion that incent (and thus favor) common stockholders. This doesn’t completely eliminate the benefit of preferred here, but in practice, it substantially reduces the modest downside protection.

Second, VCs are more focused on bigger and bigger outcomes, so downside protection is less interesting that before. Many VCs will “give” on this to get into a good deal.

Third, the participating part of preferred has morphed into other vehicles / clauses more focused on pricing protection. A 3x-5x “participating preferred” clause is now rare, vs. common in the old days (i.e., preferred would get 1x back and then full pro-rata proceeds until they made 3x-5x). What is more common nowadays, with the explosion of later stage capital, is either an IPO price floor (to guarantee a return at IPO) or other “adjustments” and ratchets to later rounds. So instead of taking a little more out of the pot in a smaller outcome, later-stage VCs have traded that for more price protection.

So today, preferred still has a real advantage, but the benefits have changed a bit. They are more focused on improving & protecting pricing in later rounds vs. what happens in more modest outcomes.

But because the advantages have changed, more and more VCs are fine buying common stock on the secondary market, generally for a discount of some form.

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Published on July 9, 2019

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