Jun 9, 2019

Why do venture capitalists almost always receive preferred stock?

"Secrets of Sand Hill Road" is the new book from Andreessen Horowitz venture capitalist Scott Kupor, blurbed by former Google CEO Eric Schmidt as being "the definitive book on navigating VC."

The big picture: The capital that VCs provide is no longer scarce, says Kupor. It's entrepreneurs who deserve the real credit for building successful companies, not the people who staked them. And yet, he explains, VCs nearly always receive preferred stock, which gives them many more economic and governance rights than the firm's founders or employees.

What they’re saying: Kupor walks his reader through a typical term sheet where a group of VCs is taking a 20% stake in a startup company for $10 million. The lead investor, with about a 10% stake, will control a majority of the preferred stock. Pretty standard "protective provisions," explains Kupor, mean that the VC investor will "get to vote on" new classes of stock, "have a say in" certain corporate actions and recapitalizations, and "be able to weigh in on" changes to the employee option pool.

  • What they’re not saying: Kupor neglects to mention that these provisions don't just give the preferred shareholder a vote or a seat at the table; rather, they give the VC unilateral veto power over all such actions. It's not clear why a 10% shareholder should be so powerful, especially given that the ability to fund the company is much less rare than it used to be.
  • I asked Kupor about this, and he said that he was open to the idea of VCs taking common stock instead of preferred stock — on the understanding that valuations would be lower, as a result. That seems like a good idea to me, in a world of unicorns where no one is complaining about valuations being too low.

My thought bubble: Investing in common stock is certainly risky. In a worst-case scenario, the founders could just liquidate the company immediately, take 80% of the $10 million for themselves, and give just $2 million back to the VCs. But VC is a risky business. If VCs don't have a basic level of trust in founders, they shouldn't be backing those businesses in the first place.

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