Seed investors should buy common stock

Weekly digest Nov 1, 2024

We like to say we’re the most aligned investors a founder will ever have and that we’re effectively buying common stock. This is basically true. We invest so early that if push comes to shove on the preference stack, we’re usually sitting under the same liq pref as the founder. But it’s not literally true. We, like every other seed investor, don’t buy common stock we buy preferred. This is dumb.

Preferred stock is largely about downside protection but we don’t value downside protection because there’s nothing to protect. Our companies have no cash flow and no assets; they’re worthless by any rational accounting. When they fail, we expect to get nothing. And as for “getting our money back” a 0.5x or 1x is the same as a 0.

We only care about the upside. Buying preferred stock is a bizarre legal anachronism that throws off the balance that brings seed out of alignment with common (founders and employees).

I'd happily buy common stock at a discount. And founders should be willing to sell it to me - less chance of them walking away with $0 in a mediocre outcome AND they’d increase their de facto control.

The problem is that founders basically don’t care about common vs pref. Like VCs, Founders ALSO only care about upside. So even though the downside protection through liq pref is worth something greater than 0, founders won’t accept a lower price in exchange for giving it up.

We know no one cares because no one cared when some funds started taking on their own legal bills. No is winning deals or getting better prices by buying common stock or massaging legal terms - at least not in companies they’d actually want to own/invest in.

So we’re overpaying for something we don’t value and buying it from someone (founders) who don’t consider it at all. There’s a fundamental cultural inertia here that will probably never change but if we’re ever negotiating and you want to be more aligned we can work something out.

Here are reasons to keep the system as they are that people on twitter pointed out:

1. Buying common messes with the 409a valuation. If you have pref, you can create a pretext for valuing the common at near-zero which is good for employees.

2. Preferred and common makes it harder to do fraud and steal from investors. Better legal protections make it easier to do business with “out of network” people.

These are both good arguments but don’t address the central claim that liquidation preference and seniority is stupid: it doesn’t drive returns but DOES wind up hurting founders in the event of a mediocre exit (second most common outcome after outright failure). 

Just because there’s no appetite to change it doesn’t mean it wouldn’t be worth innovating a solution.

I wrote

• Seed investors should buy common stock

• Time to go long system integrators and consultants

I read

• Liquid vs. Illiquid Careers  - Vaishnav Sunil on Substack

• 21,000 laborers have died working on Saudi Vision 2030