The Unfairness of Fair Deal Terms
Updated: Sep 5, 2018
When you book a preferred seat in an airplane, you pay a higher price than a passenger who books a common seat. Most of us would agree that it is fair and intuitive that we pay more for a preferred offering than for a common offering, simply because it is better and therefore more valuable.
Yet when you look at the financing of young companies, this rule of common sense does not seem to apply: Venture capitalists generally obtain preferred stock at the same price as common stock. This is (generally) wrong. It leads to a reallocation of value from the founders to the venture capitalists, and it further dilutes the ownership stake of the founders.
As it turns out, this flaw is present in most of the venture capital term sheets, even the ones that are intended “to remain fair to both investors and the founders,” such as the Simple Agreement for Future Equity (SAFE) that was introduced by the great Silicon Valley venture accelerator Y Combinator. Unfortunately, it is also present in many entrepreneurial finance and venture capital courses at reputable business schools. Yet, a mistake that many people make is still a mistake.
How is the issue price computed?
In a term sheet, the valuation of a company and its shares is usually based on the so-called pre-money valuation, which is the assumed value of the firm’s equity right before the new financing round. This pre-money valuation is then divided by number of shares of common stock outstanding to obtain the “fair” current stock price.
For example, suppose a firm has a pre-money valuation of $10 million and 5 million shares of common stock outstanding right before the new financing round. The numbers imply that the “fair” price per share of common stock is $2.
To compute the number of shares that the firm will issue to the new investors, the term sheet then typically divides the amount of investment by the “fair” stock price that we have just computed. For example, if the investors contribute $2 million, the company will issue 1 million new shares to them at a price of $2 each. After the investment, there will consequently be 6 million shares outstanding and the value of the company, the so-called post-money valuation, will be $12 million, i.e., the pre-money valuation of $10 million plus the capital injection of $2 million. The stock price remains at $2.
So what exactly is unfair about this deal?
In principle absolutely nothing! The deal structure that we have just described is perfectly fair if the investors receive the same type of shares as the original shareholders. Yet that is generally not the case! Especially in the context of venture capital financing, new investors generally receive so-called preferred shares.
As the name already suggests, these shares receive preferential treatment compared to shares of common stock. In fact, many of the clauses in the term sheet deal with the specifics of this preferential treatment in terms of return allocation, control rights, and exit provision.
For our purpose, the most important type of preferential treatment is the combination of liquidation preference and conversion rights. This allows holders of preferred stock to choose whether they want to get their money back before any payments are made to holders of common stock; or whether they want to convert their shares of preferred stock into shares of common stock. So the preferred stock will never get less than the common stock, but oftentimes more, namely when the holders of preferred stock choose to get their money back. It follows that one share of preferred stock must be more valuable than one share of common stock.
How does it affect the distribution of value?
The chart below shows this more clearly, using the numbers from the previous example. On the horizontal axis, it shows the firm value at the time of liquidation, and on the vertical axis, it shows the resulting stock valuation. As a reference, the black line shows the (hypothetical) stock valuation if the firm had only issues shares of common stock. Remember from above that there will be a total of 6 million shares outstanding after the new financing round. For example, if the firm will be sold for $6 million at a future point in time, each share will receive a payout of $1. In contrast, if the future valuation is $12 million, each share will receive a payout of $2. Regardless of the future state of the world, shareholders will be treated equally.
The red line and the blue line now show how the combination of liquidation preference and conversion rights affect the value allocation among shareholders. Let’s assume that the preferred shareholders have a 1-time liquidation preference, that is, their liquidation preference corresponds to the original purchase price of $2 per share of preferred stock. Let’s look at a few possible outcomes:
Liquidation value of $1 million: If the firm’s liquidation value is $1 million, holders of preferred stock will insist on their liquidation preference. Given that the firm has 1 million shares of preferred stock outstanding, each share of preferred stock will receive a payout of $1. The liquidation preference will consume the full value of the firm, so that the holders of common stock receive nothing.
Liquidation value of $2 million: At a liquidation value of $2 million, preferred stockholders will receive their full liquidation preference of $2 per share. Common stockholders still receive nothing.
Liquidation value of $6 million: Preferred stockholders will still opt for their liquidation preference of $2 per share. Consequently, a total payout of $2 million will go to preferred, and the remaining $4 million will go to the holders of common stock. With 5 million shares of common stock outstanding, each share of common stock will receive a payout of $0.80.
Liquidation value of $12 million: At a liquidation value of $12 million, preferred stockholders are indifferent between liquidation preference and conversion into common stock. If they convert into common stock, there will be a total of 6 million shares of common stock outstanding, and each share will receive a payout of $2. Consequently, each share of stock (common and preferred) will receive the same payout of $2.
Liquidation value larger than $12 million: Finally, if the firm’s liquidation value exceeds $12 million, preferred stockholders will convert their shares into common stock, so that common and preferred stockholders receive the same payout.
Clearly, the payoff profile of a share of preferred stock is much more favorable than that of a share of common stock:
There are situations in which preferred stockholders receive money and common stockholders receive nothing at all;
there are other situations in which preferred stockholders receive much more money than common stockholders;
and it never happens that common stockholders receive more money than preferred stockholders.
Looking at it like this, one would probably agree that preferred stocks (red line) are systematically more valuable than common stocks (blue line). Consequently, the issue price of a preferred stock should be larger than the (implied) value of a common stock. If not, issuing preferred stock will inevitably reallocate value from the common stockholders (the founders) to the preferred stockholders (the investors)!
Why do most term sheets ignore this simple regularity?
That’s the million-dollar question. The most obvious answer is that term sheets are generally prepared by the investors. If these investors can buy preferred stock at the price of common stock, they benefit from a systematic underpricing and, consequently, improve their expected return (at the expense of the founders).
Another argument could be that the founders are generally more optimistic and, therefore, tend to overvalue their company. By issuing preferred stock at the price of common stock, investors can protect against this overvaluation. While it is generally true that founders are more optimistic, this argument is flawed. The reason is that it is the investors who generally come up with the pre-money valuation, so there is no reason to believe that the valuation is systematically biased. And even if it were, issuing preferred stock at the price of common stock would be a fair correction for this misevaluation only by coincidence. It would be much more transparent to apply a discount of, say, 20 percent to the valuation and base the (fair) stock pricing on that discounted valuation.
And the third argument is that it is difficult to value preferred securities, since it involves option pricing. This is true, especially in the context of startup companies. Readers who are interested in how to approach the valuation of preferred securities, please follow this link. Yet even if it is difficult to price these securities, there is no reason not to try it. Or at least to make a rough adjustment to the issue price for the fact that preferred stock has liquidation preference.
So is preferred stock bad for founders?
Absolutely not! Preferred securities are excellent financing instruments, and they play a very important role in the financing of (young) companies. As is discussed extensively here, preferred securities very often help to bridge valuation gaps, provide high-powered incentives to the entrepreneurs, and allow investors to screen out less confident entrepreneurs. They often make deals more valuable.
All we are arguing here is that preferred securities should be fairly priced. Most venture capital term sheets do not price them fairly. In most instances, investors can buy preferred securities at an underpricing, compared to the shares of common stock. This reallocates value from the founders to the investors. And, by the same token, it leads to (excessive) dilution of the founder’s ownership stake.
******************** Interested to learn more about term sheets?
Follow this link for an in-depth discussion of deal structuring and term sheet negotiation.
And follow this link to better understand the valuation challenges and their solution in the context of startup companies.