Numerous types of private securities are being sold to investors via online investment platforms. Investment crowdfunding has opened up a new market for all investors – including non-accredited investors. While debt is less risky than equity, in general, the returns may be limited if a company has a good exit. But when it comes to equity, common shares may lose out to preferred shares if the company is acquired for a lower valuation than the funding round when the investor bought shares. Liquidation and dilution rights count – a lot.
Carta has a good explanation of the two options. In an event where a company is sold for less than originally invested, the preferred may receive their entire investment back. For common shareholders, you may end up with zero. As many, if not most, early-stage ventures fail, investors should consider this possibility when investing in crowdfunded companies.
An important characteristic of a security is liquidation rights. Preferred tends to be at the head of the queue while common shares are at the end of the line. But if an exit is at a higher valuation than the original investment, a preferred shareholder should have the option to convert the shares into common equity if that will generate better returns. And preferred shares typically generate a dividend, another quality an investor should consider.
CommunityRoundVentures has distributed a report on common vs. preferred, which states:
“The most important protection that is almost uniformly in place when “smart money” invests is that they have liquidation preference over founders and often over all previous investment rounds. Most funding in the institutional market is done through preferred stock, not common stock, and there is a HUGE difference.”
Adding, “…Just say No to Common Stock and let founders and platforms know this is just not fair!!”
Experienced investor Michael Knox, President of Gold Ridge Asset Management, criticizes the prevalence of common equity being issued by Reg CF issuers as “both disturbing and sad.”
“The platforms are taking advantage of the lack of sophistication of the retail investors by issuing securities that are far inferior to those being purchased by most VC or angel investors,” says Knox, who adds, “The long-term health of equity crowdfunding will depend on investor outcomes and the platforms should insist on the proper security structure and terms to balance the fairness to both issuers and investors.”
Knox is also the founding investor and CEO of Crowdlustro – an investor relations platform for Reg CF issuers.
Just last month, Wefunder, a regulated Funding Portal, posted a missive as to why preferred shares are advantageous. Christopher Vail stated:
“Companies raising priced rounds should offer preferred stock to their investors. Retail investors – the true fans, customers, and early adopters – deserve the same protections as professional investors if their favorite company fails. If the goal is to bring the community along for the ride, they shouldn’t be given inferior terms to institutional investors. Further, down the line offering common stock can end up hurting employees, and indirectly the company itself.”
Vail does add that “there are rare exceptions where common stock could make sense – for example, a hot late-stage company with low risk of failure, or a small business where existing professional investors hold common.” Vail noted that Wefunder focuses on offering preferred shares.
All of the above highlights why VCs or experienced angels tend to want preferred shares instead of common equity.
Crowdfund Capital Advisors (CCA) recently reported that in Reg CF securities offerings, common shares are the most popular type of security issued, followed by SAFEs. At the same time, preferred offerings tend to raise the most money.
In the end, understand the security you are purchasing and the risk involved. Participating in private securities offerings for promising young firms can be very rewarding but as with any investment you can lose money. The viability and sustainability of the securities crowdfunding industry will be contingent upon issuers being able to raise the money they need to execute on their vision, platforms making enough money to become profitable, and investors being able to get a return on their investment on a portfolio basis – just like professional investors and big VCs.