Should startups let investors buy common stock?
A founder sent me a question about an investor buying common stock. With her permission, I’ve shared the question and my response.
Hi Drew,
Quick question for you if you have time. We have an investor who is interested in buying a large tranche of common equity as a pre-seed round (somewhere between 10–15% of the company) and he wants to buy it as common stock rather than preferred (says it makes the deal simpler).
We have not heard of investors ever getting common equity and any articles about it are a few years old so we wanted to ask directly what your perception of the cap table would be if an angel came in for common equity. Any other words of wisdom on the matter would be greatly appreciated.
Thanks!
My response:
That’s an unusual ask. I can’t think of a way that would make the deal simpler and it’s probably more complicated than just doing a SAFE/Note. Your lawyers do a lot of the latter so are straightforward and cheap to execute. It’s unlikely they’ve done many sales of common stock so they will have more work to do on it.
It does create some issues with valuation. Common is normally valued a discount of preferred (typically 10–40% of the price of preferred at your stage), so maybe he’s trying to pay that price. If so, I don’t think giving him that discount is fair to you. It also could create issues with the valuation you get from next round investors.
If he’s going to buy common at the same/similar price as preferred, it can cause problems for things like stock options. Normally the spread between common and preferred is helpful for employees as the strike price of their shares is well below what investors are paying. If you took his money for common, it will be hard to say that the fair market value of common is lower than preferred, so you’ll have to start issuing options at the valuation he’s putting money in. And if you’ve recently issued options, the strike price you set may be called into question for tax purposes. Normal caveat that I’m not a lawyer or a tax professional.
tl;dr — It’s odd and not something I’d likely recommend because of the legal complication and potential issues with valuation.
cheers,
Drew
