The difficulty of tactical maneuvering consists in turning the devious into
the direct, and misfortune into gain.
– Sun Tzu
A number of you wrote me after my post on "The Power of Dry Powder". Many of you have heard about contentious situations between investors in the same company and were curious about how this comes about. I will lump most of this discussion in the bucket of "class warfare". During periods of "misfortune", many later round investors turn things into gain at the expense of earlier investors.
As a company grows, it takes on multiple rounds of investment. This usually constitutes several "classes" of convertible preferred stock, with each designated alphabetically (Series A, Series B, etc). The founders and angel investors often have common stock which is junior to the various preferred stock series.
Each new round usually has at least one, if not more, new investor(s) to price the round and set the terms independently. The new class of stock is usually senior in liquidation to the series before it. So, if Company A raises $2M of Series A, $5M of Series B and $10M of Series C, investors in Series C get their money first, Series B next and then Series A. If there is enough left over, the common gets the remaining unless it is participating preferred. This means the preferred get their money out and then participate in the remainder with common based on their % ownership in the company.
Different classes with different rights and seniority creates a broad array of misaligned interests:
Acquisitions: If the Company gets an acquisition offer for $11M, the Series C investors might push to sell if they have lost faith in the business. They get their $10M back (and the Series B gets $1M). However, the B and Series A would not want to sell since they get little. If they have blocking rights, they will prevent the sale from occurring. This happens when major decisions (sale, new capital, etc) must be voted on individually by each class versus combined by everyone (pari passu). In the later case, the C would be able to push through a combined vote since its $10M is greater than the $7m from the other two classes combined (assuming simple majority, etc).
New Capital: When new rounds of capital are raised, all kinds of games can begin. If the older investors are tapped out, the recent investors are not overly excited about carrying the company for the free riders. So, they throw in a pay to play. In this situation, old investors have to invest their pro rata (% ownership of the preferred) or their preferred stock gets pushed to common. This means that even if you are a Series B investor, if you don’t invest your full amount, your Series B stock converts to common and falls behind the remaining Series A, B and C stock. This is particularly nasty if there has been a lot of money raised. Let’s say there is $20M in each of the classes and you are a Series C investor. Before the new financing, you needed a $20M exit to get your money back (C comes out first and was $20m in total). If new money comes in (say $10m) and you don’t invest your pro rata, you get pushed to common and now need a $70m (minus your investment) exit just to get your first dollar out (A,B &C are $20m each and the new D is $10m). You then participate with everyone based on your % owned in the company. If you invested $10m and own 20%, then you would get your full money back $50M later. So, before, you needed a $20m exit to get all of your capital out and after the Series D came in, you need a $121M exit ($60m in remaining preference ($70m-your $10m) ahead of you and $50m for ownership).
It is for these reasons, that investors like to have blocking rights on sales and financings. This means that they own enough of a Series (or they and "aligned co-investors") that the Company needs their approval to sell or raise. This prevents a pay-to-play from being crammed down on them.
There are a vast array of other scenarios, but these give you an initial feel for how messed up syndicates can get when a) classes have different rights and b) investors begin to run out of capital. Since angels often don’t have sizable reserves for future rounds (or don’t know to save for them), they often get hammered during these kinds of financings. I have had my share of both sides and can tell you, like at Christmas, it is "much better to give than to receive". In all honesty, though, if a deal starts to take on these characteristics, no one usually wins and most of the manuveurs are like rearranging deck chairs on the Titanic..