Common Stock

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As an angel investor, from time to time you might be asked to invest in common stock.

Common stock is stock that entitles the holder to receive whatever remains of the assets of a company after payment of all debt and all preferred stock priority liquidation preferences. Common stock does not usually have any of the special rights, preferences, and privileges of preferred stock (although it is possible to create a class of common that does, such as a class of common stock that has multiple votes per share, or is non-voting, or that has protective provisions).

When a corporation is initially organized, typically only common stock is issued to the founders and set aside for issuance under the company’s stock option or equity incentive plan for service providers. (However, sometimes founders will issue themselves a special class of common stock with 10 or 100 votes per share and protective provisions.)

​important​ Though common stock can be raised in a priced round, it is not usual for angels to purchase common stock. Common stock usually has one vote per share, no liquidation preference, no anti-dilution adjustment protection, and no protective provisions. As we have previously discussed, preferred stock is “preferred” because it has these types of special preferences. However—and though many angels will refuse to buy common stock—common stock deals are not necessarily bad deals. In fact, one of the best investment returns Joe has ever seen was a $100K angel investment in common stock that turned into $20M in cash.

If you are doing a common stock deal, the definitive documents will include a common stock purchase agreement, and may include other agreements such as a Voting Agreement.

Startups’ Perspective on Common Stock

​founder​ The benefits to the entrepreneurs of a common stock round relative to a preferred stock round include:

• A lack of liquidation preference for the common stock investors.

• A lack of dividend preferences typically associated with preferred stock.

• A general lack of other voting and control provisions typically associated with preferred stock. (That said, it is possible to put many provisions favorable to the investors in side letter agreements and other definitive documents associated with the financing.)

• Significantly lower legal fees for documenting the deal.

From the company’s perspective, there are drawbacks to selling common stock to investors:

• Once the company sells common stock, it will have fixed the value of its common shares for the purposes of granting stock options. If the company sells common stock at $1 a share, it cannot grant stock options at $0.25 a share without causing any optionees to have negative tax consequences.

• In contrast, if the company sells preferred stock, it can typically continue to grant stock options, which will be options for common stock, at a price per share less than the price per share at which it sold preferred stock.

Investors’ Perspective on Common Stock

The reason angels do not normally invest in common stock is because common stock does not have the privileges of preferred stock (specifically, a liquidation preference). However, in some instances founders will not want to issue preferred stock because they will not want a liquidation preference ahead of their founder shares, and sometimes investors are willing to do this to get into the deal. The other situation where common stock might be sold is when the amount of money being raised is not large enough to justify the costs of a preferred stock round and the investors are willing to take common stock in a fixed price round rather than convertible debt or convertible equity. In general, as a rule of thumb, if a company is raising less than $500K, a preferred stock round does not make sense from a legal fees perspective, and a convertible note or equity round or common stock round makes more sense.

As the example common-stock term sheet suggests, investing in common stock can be relatively straightforward. However, as described above, there are drawbacks and potential pitfalls to consider:

​danger​If the company raises money at a lower valuation shortly after an investor’s common stock investment, the investor will not be entitled to the lower valuation (unless the investor negotiated a most favored nations or purchase price anti-dilution adjustment in a side letter or elsewhere in the definitive documents).

​danger​If the company issues preferred stock with a liquidation preference, and the company is liquidated for less than the liquidation preference, you won’t receive anything.

​important​Generally, common stock investments do not have any control mechanisms built into the deal. If you are a small investor (for instance, in the amount of $25K), it would not be reasonable for you to assert any control rights. But if your investment is larger, something on the order of $200K or more, you may want to request control mechanisms including a board seat and/or approval for certain company actions, such as the sale of the company. These controls can be built into the definitive documents or appear in a side letter.

How to Protect Yourself in a Common Stock Round

There are a number of ways you can try to protect yourself if you are investing in common stock. For example, you could have the company agree (perhaps in a side letter) that if it sold preferred stock in the future, it would convert your common stock to preferred. That would be unusual, but it is possible to do this.

Another possibility is that you negotiate for purchase price anti-dilution protection (perhaps to be embodied in a side letter agreement with the company).

Another idea is to set a pro rata right, so you can apply your pro rata right in subsequent rounds of financing by the company.

You can find an example of a side letter agreement from a common stock investment that gives the investor full ratchet anti-dilution protection in the appendix (though this is rare).