Venture capitalists are known for making apparently risky moves – investing in young start-ups still getting a feel for things, perhaps in the fluid tech or digital sectors. But these apparently risky moves are usually well-thought-out strategic investment decisions designed to ensure that if a company they’ve put money into does get snapped up, they will do very well out of it indeed. Potentially at the expense of the founder(s).
In a recent piece for the Financial Times, reporter Kadhim Shubber focuses on the different classes of shares that VCs hold in companies they invest in, showing that they tend to have ‘preferred’ shares that give them a priority ticket in the event of a sale.
Using music streaming website Soundcloud as an example, Shubber shows how company founders who allow VC investors to hold preferred shares could end up without a penny in the event of a sale.
Soundcloud’s founders Alexander Ljung and Eric Wahlforss have raised nearly $200 million in six funding rounds since the firm’s inception back in 2007. The company has been valued at $700 million.
But in each of those funding rounds, new and incoming investors have added extra layers of protection for themselves, Shubber explains, building a “preferred stack that has pushed Ljung, Wahlforss and other non-preferred shareholders further back in queue”.
What this preferred stack means is that should Soundcloud sell, investors will either get paid a price per share that was agreed the day they invested, or convert their preference shares to ordinary shares, taking the per-share price offered by the buyer. It goes without saying that they would opt for whichever route gives them the biggest financial gain.
Now, if the preferred shareholders go for the first route – the pre-agreed price – then the remaining non-preferred shareholders divvy up whatever’s left over. “Depending on the sale price, that might not be very much,” Shubber notes.
The reporter dug out financial information from Soundcloud’s filings with Companies House and found that the total amount of cash due to the preferred shareholders if they choose to take the pre-agreed price per share “comes to around $170 million plus €30 million, which is about €187 million or just over $200 million.
“If Soundcloud was sold at that low a price, the non-preferred shareholders, including the founders, would likely not receive a penny.”
What’s more, if the selling company has debt, which Soundcloud has had, such liabilities would come ahead of even the preferred shareholders, complicating things further.
“When times are good, this sort of structuring gives investors downside protection and incentivises a founder to build as big a business as possible so they can sell at a price that dwarfs the preferred share stack, thus maximising their own payout,” Shubber explains.
“But when a big exit looks less likely, you may end up with a founder who wonders why they are still losing sleep and weekends when they’re unlikely to get a look at the value they’re creating.
“Which is how, as a founder in a tight spot, you might negotiate a payout when your company sells, even if you’re meant to be at the back of the queue.”