tech

The risks of being a small investor in a private company

With the passage of the JOBS act, it seems that many more Americans will soon be able to buy equity in private companies. I am no expert on the law, but I have been investing in private companies for about a decade, and during that time I’ve seen many cases where large investors used financial engineering to artificially reduce the value of smaller investors’ equity. Here are a few examples.

1) Issuing of senior securities with multiple liquidation preferences. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m, getting 4x senior straight preferred

Company gets sold for $30m. Management gets $3m carveout, Series B investors get $27m, and Series A investors get zero.

2) Issuing of massive option grant to management along with new financing at a below-market valuation. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred for 10% of the company.

Company is doing well and is offered a Series B at a significantly higher valuation. Instead, large investor invests $5m at below-market valuation, getting 40% of the company, and simultaneously issues options worth 50% of the company to management.

Result: Series A investors are diluted from 10% to 1% of the company, even though the company was doing well and in a normal financing would have only been slightly diluted.

3) The company is actually multiple entities, with the smaller investor investing in the less valuable entity. Example:

Company has entity 1 and 2. Small investors invest in entity 1 that licenses IP from entity 2. Value of IP increases and entity 2 is sold and eventually cancels entity 1′s license, making entity 1 worthless.

4) Pay-to-play or artificially low downrounds. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m in pay-to-play round (meaning any investor that doesn’t participate has their preferred shares converted to common). Smaller investor doesn’t have the cash to re-invest in Series B, but deeper pocketed investors do.

Company sells for $10m. Series B investors get $10m. Series A investors get nothing.

There are ways to protect against these shenanigans. Protections can be written into the Series A financings documents (pro-rata rights, ability to block senior financings, etc). There are also some legal protections all minority investors are granted under, say, Delaware or California law. But usually even when these protections exist (and they exist far less frequently these days than in the past), smaller investors usually can’t, say, invoke blocking rights by themselves (indeed, it’s often not economically viable for smaller investors to hire lawyers to review every financing document for every company they invest in). Another way smaller investors can protect themselves is to set aside capital amounting to, e.g. 30% of every investment made, in case they need it later for defensive purposes (I do this). But in my experience this is all very complicated and difficult to execute in practice, even when the small investors are “professional” investors. I worry it will be even harder for “amateur” investors to protect themselves.

Categories: tech

3 replies »

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