Katherine Murray · Follow
4 min read · Jun 15, 2016
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VC funding terms create a significant shift in the economics of a startup, changing the payoff profile for founders. If you’re a founder or employee of a startup, this 5 minute read tells you what you need to know.
Seed rounds: ordinary shares
Investment in seed rounds typically takes the form of ordinary shares: founders and investors own the same class of shares, taking the same level of risk in the capital structure of the firm.
Most early rounds take advantage of SEIS or EIS tax breaks, which offer huge tax reliefs for investors. These tax breaks are designed to encourage investors to put genuine risk capital into early stage businesses, and therefore require investors to take the same economic risk as founders by investing in ordinary shares.
VC rounds: preference shares
Larger and later stage VC investments usually don’t benefit from SEIS or EIS. It is typical for later stage VCs to insist on investing in a separate class of shares carrying less economic risk than the founders’ ordinary shares. These are known as preference shares.
VC preference shares usually have the following features:
- They rank ahead of ordinary shares in the capital structure, with a liquidation preference that guarantees that the VC can get his money out before the founders.
- They accumulate a dividend at a set rate; this dividend has to be paid before founders can take a dividend from the company.
- VCs can switch them into ordinary shares if they wish; this typically happens if the ordinary shares (which don’t have a set dividend rate) have overtaken the value of the preference shares (which have a set dividend rate).
It’s a have-your-cake-and-eat-it solution for the VC: they get their capital protected if the business doesn’t go that well and they get the option to switch back into ordinary shares to get the full upside if the business takes off.
Founder Payoffs
Lets look at the impact of these terms on the founder’s payoffs.
Ordinary Shares.
An investor invests £10m for 20% of equity, investing in ordinary shares. Three years later the company is sold. The chart below shows the payoff structure: the “y” axis shows the proceeds for each participant in £million; the “x” axis shows the sale price.
Preference Shares
An investor invests £10m for 20% of the equity structured as a preferred share with standard VC terms*. Here’s what the payoff structure for a 3 year sale looks like now:
The preference share structure gives the VC reassurance that his money will be returned in a slow growth scenario, and may make him comfortable investing at a higher valuation.
However, the entrepreneur receives very little return if the business achieves only moderate growth: he gives up the possibility of making a decent return from a small exit.
The Impact of Prefs
Preference share structures actively disincentivize small exits. This is a sensible alignment of interests from the VC’s perspective: VC investments tend to follow a power law distribution, where just a small percentage of successful investee companies provide the overwhelming majority of returns. For VCs, it makes sense to encourage entrepreneurs to think big.
Once the entrepreneur has given up the possibility of small exits, his incentives are to play either for a strike out or a home run. This strongly favors the adoption of high risk / high return strategies which aim to gain market share rapidly, frequently by optimizing for growth rather than revenue. Such strategies tend to incur high capital burn rates, increasing the need for further VC funding rounds to fuel the required growth rates. This magnifies the problem.
As VC rounds accumulate, later stage startups end up with a series of VC preferences on their cap table — known as a “preference stack” or “liquidation stack”. Preference terms typically become more pronounced in later rounds, and there has been a reported increase in the downside protection offered to investors in so-called unicorn companies, who often insist on preference terms to justify high valuations.
If the preference stack is large enough, ordinary shareholders may find that their interests are not worth much, even where the valuation looks high on paper. Should tech valuations fall — or should high-growth unicorns fail to keep up with investor expectations — even unicorns with $1bn plus valuations may not provide much of a return for those outside the preference stack.
Founders need to be live to the consequence of preference share structures, and weigh the risks carefully to ensure they don’t sleepwalk into an incentive structure that materially increases their risk profile.
However, this is no longer just an issue for founders. As employees of start up companies typically take options over ordinary shares, this should be a concern for them too. If you are taking a job with a late stage startup, take the time to understand the capital structure to make sure that your options really will be able to give you the reward that you expect for your hard work.
