Each board member has an obligation to represent all of the shareholders and do what is in their best interest. In a simple cap table, where common is the only class of stock, everybody is in it together. All parties have the same interest, and share in the same outcome. What benefits one investor equally benefits all investors.
Unfortunately, this utopia has been dramatically distorted in most venture and growth-equity backed companies. The typical investment vehicle for institutional investors is preferred stock, or a similar instrument that puts the institutional investor at the front of the line when there is a liquidity event. They put their money in and want to be assured that they will be repaid before any common shareholders see a penny. In most cases, the preferred shareholders have the right to convert their preferred shares to common if the outcome is large enough that the common shares are more valuable than the preferred, so they win no matter what.
Preferred investors have gone even further with a few more aggressive forms of investing. One form is to structure their investment so that rather than having to choose either the preferred return or convert to common, their preferred shares get repaid (usually with interest), and then they also get a second bite at the apple by converting their shares into common and participate in the common shareholder payout as well. A second aggressive form of preferred investing is a preference multiple. With a preference multiple, the initial investment must be repaid two or three times before any funds go to common shareholders. In particularly egregious situations, investors may demand a preference multiple and participation rights, taking a second and third and possibly fourth bite at the apple.
The whole thing gets even more messy when there have been multiple rounds of institutional investments with different investor groups. The Series A preferreds may have different rights or economics than the Series B or C or D, and the waterfall of who gets what in a liquidity event can become wildly complicated. If the outcome of the sale is big enough, everyone gets a payday, but if the sale does not clear the entire preference stack, somebody is going to be disappointed, and the common shareholders are at the front of that line.
So what does this all have to do with conflicts of interest? Creating a collection of stock classes , particularly where the investors in each class include different institutions, introduces a governance challenge for the board. As noted at the top, each board member has an obligation to act in the best interest of all of the shareholders. However, the typical practice for an institutional investor is to require a seat on the board for a member of their investment firm, and that member’s first obligation is to their own firm. An exit that is acceptable to one investor may disadvantage another investor, just as the economics of the preference stack as a whole may disadvantage the common holders. So, who are the board members really representing, and whose best interest are they pursuing?
Let’s look at some examples that complicate this picture within the preferrence stack. Each investment fund generally has a limited timeline for holding an investment. An investor in Series A may make their initial investment expecting to exit after 3 - 5 years. However, if a new investor leads the Series C round two years later with an investment horizon of an additional 5 - 7 years, then the board members for these two groups are not aligned on their exit horizon. It is not unusual for exits to be driven by fund timing, and not by what is best for the business - aka common shareholders.
The same type of situation can occur when different series are led by different styles of investor. An early stage venture investor may have led Series A, while a later stage private equity investor may have led Series C. The venture investor is looking for high growth and is tolerant of losses or low earnings, while the PE investor is satisfied with more modest growth, but intolerant of losses or low profitability. The board and the CEO have to navigate these conflicting objectives and maximize the outcome for all of the shareholders, but it is challenging for the investors to take off their firm’s hat and put on their board hat.
When a company is doing well and everyone can see a fantastic exit approaching, most of these representation and governance issues fade into the background. Problems arise when the business is on a less attractive trajectory. It is really a problem if the company needs to raise more capital and some investors are open to the idea while others are eager to head for the exits. This is exacerbated when one of the funds is nearing the end of its lifecycle, and there is no additional capital available for them to invest. An investor who cannot participate with their pro rata share of a new round is often punished by the economics of the preference stack. As a result, they may press to sell the company rather than open the door to new investment. That might be good for them, but not necessarily good for the rest of the shareholders. The board member from that investor will face the dilemma of supporting what is good for the business and the other shareholders, or what is good for their fund. A pretty clear conflict of interest.
There are all sorts of justifications for creating multiple classes of stock. Institutional investors point to their capital as a high-risk investment that provides the lifeblood cash to fuel the business, so surely they deserve an outsized return. The problem is that this stuff gets out of control and the common shareholders, which includes the founders and the employees and the early seed investors, are the ones that suffer the most. We have all seen preference stacks with multiples and accumulated interest that far exceed the current enterprise value of a business. However, when the investors want out, the business will be sold. The preferreds may get two or three times their money, but the commons will get zero. This is the bargain that was struck when the money was invested, but it does not lessen the sting.
The economic model of the venture and PE industry is complex. These investors provide a vital engine to realize the creativity, innovation, and growth of breakthrough products and services, and they deserve returns commensurate with the risks they take. I do not have a perfect solution, but my observation is that the concept of multiple classes of preferred shares and the complex structures that have evolved to ensure outsized returns has created a monster. If we look at enterprise value more simply, then the price paid for shares should be able to reflect the risk and reward to support institutional investors needs. Rather than frame the investment as ‘I should get twice as much for my share as you get for yours,’ why not price it so that ‘I will pay half of what you paid, but we end up with the same class of shares?’ Alternatively, if the structure has to be ‘I get mine before you get any,’ then maybe the answer is a single preferred class and a single common class where preferred holders get paid before common holders. Within the preferred investor pool, we should be able to deal with varying returns through pricing, rather than the creation of new classes. There is probably no simple answer that will mimic the complex waterfalls we see today, but eliminating the conflicting agendas will enable board members to truly represent all of the shareholders without all of the inherent conflicts of interest the current system creates.