If Common Stock Is Worthless, What Does That Mean for Entrepreneurship?


Plain common stock has become largely worthless in funded companies. Preferred shareholders have increased their rights and protections, while liquidity events have become rare. Meanwhile, common stock has remained largely unchanged, having value diminished by the changing world.

There is an argument that creating value in common stock may help to improve returns from private equity and venture capital. Common stock is the foundation of entrepreneurship. It is the basis of management compensation, employee options and voting control. Creating the opportunity for management to make real returns from their common holdings creates an alignment of interest with investors. How can you attract the best talent and the best opportunities when the compensation model is broken? Any experienced entrepreneur, investor or wise employee understands that an extraordinary success is required to wrest any value from common stock when there are outside investors involved.

Let’s look at a simplified example to identify some of the problems with common stock. A five-year-old company with $10 million in revenues decided to sell for $50 million in cash. The company has raised $10 million for 25% in preferred stock. The investors have a 1.5 liquidation preference that provides them with $15 million on exit, and they also participate at 1/3 of the remaining proceed as a result of preferred dividends, providing investors with roughly $27 million of the $50 million in proceeds. If you pull 10% off the top for closing related expenses, common stockholders are left with just under $21 million.

In this example, a CEO with 10% in common will stand to earn $2.1 million on a 5x revenue sale for $50 million. An investor with 10% in preferred will stand to earn $10 million. It is likely that the CEO has taken below market compensation for years to get the company off the ground, which may average out to $500,000 of lost wages over five years, assuming that the CEO earned nothing for some period of time. It is also likely that the common shareholders, who are often management and employees, will be asked to bear the burden of an escrow, earnout, or other type of holdback. If 20%, or $10 million, is held at the time of close, the CEO would walk away with $1 million, $500,000 of which makes up for lost wages. This simplified example does not factor in the impact of having to purchase options, which diminishes the value of common further.

Improving the value and protections of common stock is challenging. Investors have come to expect certain rights that have built up over time. Law firms use templates to generate incorporation agreements and bring common stock into existence. Expectations have been set within established companies, and changing existing agreements is time consuming, expensive, and difficult with no guarantees for success. Changing the definition of common in new companies runs the risk of scaring away investors, unless the companies are exceptional.

On April 16th, the Founder Institute, a new training program for startup founders, incorporated as a Delaware C corporation and introduced new Class F common shares. Some of the terms in Class F stock are far reaching, only able to be justified by the best new companies. Class F stock offers founders a suite of protective provisions, 2:1 Board votes per Founder versus normal Board Members, and 10:1 share votes as compared to normal common. Participating Class F shares vest monthly without a cliff to act as compensation for founding teams, and “single trigger acceleration” allows one Founder to leave without hurting co-founders. Class F holders get acceleration on change in control and approval rights on new investments, liquidity events, Board size, and dividends.

Over the next months, only the best companies will raise money, anyway. In the negotiation about whether a Class F right should survive through an investment, some preferred terms may be reduced or eliminated. Hopefully, there will be a meaningful discussion about the rights and value of common stock in the new world. The companies in the Institute will use the Class F incorporation documents, which are also freely available below:

http://www.founderinstitute.com/information/agreements

Adeo Ressi is founder and proprietor of TheFunded.com

Sign up to our Newsletter

Receive updates from our PE HUB Wire and Top Stories of the Week newsletters:

We will not send you spam, and we don't share your email address with 3rd parties.