One of my very early angel investments made 12 years ago now taught me an essential lesson as an early stage investor.

What lesson is that?

The preference stack.

I would argue that you have not truly lived as an early stage investor until you have directly learned this lesson with your own money and experienced it first hand.

So, what is a preference stack?  In its simplest explanation, it is the rights and preferences that come along with each new equity round or bridge round a company raises.  When all is going swell, everyone wants to keep riding the wave and the company has significant leverage to negotiate the terms. If things aren’t or were and now there has been hiccup, that leverage shifts to the investors and, in many cases, the new investors who have not been on the cap table since the beginning.

How can this negatively impact you as an angel or pre-seed investor?  Well let’s just say you invested first check in on a company at a $5M valuation. Company executes and raises more money at a $10M valuation. On paper you are doing pretty good. Along comes a Series A based on even stronger performance at a $40M valuation. Everybody is feeling good and you are getting much sought after but not bankable markups.

And then a hiccup. Could be a missed quarter, a competitive shift in the market not in the company’s favor, whatever and it really doesn’t matter but it informs the next financing the company has to do be that a bridge (via convertible note likely b/c it is debt like) or equity of some sort. Either way these things can have liquidation preferences meaning that money gets paid 2-3x or whatever back first and/or participation rights meaning they get their preference money then get in line ahead of you and other shareholders to take more proceeds and/or some type of accruing dividend that builds up a cash payable to the investor(s) due upon sale. They can even re-price previous investors and force them to common shares via a recapitalization (that is a topic for another post).

So let’s just focus on the gnarly liquidation preferences and other things that puts the latest money in front of your first check in terms of payout.

This is the situation I experienced. Early check into a company in a small round. Things were going great, then not so great. A couple of rounds where the company was not dictating the terms and the preference stack was primed and ready to fall on not just preferred share investors but all the holders of common stock (ie, mostly founders and employees) who don’t have the rights and preferences that come along with preferred shares.

The company got acquired by a bigco in a cash deal about 6 years after my investment. Lots of buzz and coverage. High fives online, etc. Looked like a great deal and the purchase price was actually pretty strong.

However, I got crushed by the preference stack. The money that had come in at the Series B then Series B+ then a bridge note then several other things to keep the company funded all stood ahead of me at various liquidation and participation preferences.

I received zero. There was nothing left for my share class after all the other bites were taken out of the apple including nothing left for the common shareholders other than jobs for most employees with the acquiring company.

How do you stop this from happening?  Hard to do if you are an individual, a small fund, or only an early round (pre-seed, seed) investor. There are some things that can protect you a bit as a preferred shareholder to grant you the same rights as next issued shares but those can and frequently do evaporate as a company goes through subsequent rounds. 

Very much a golden rule model – those with the gold make the rules.

This “feature” of early stage investing reinforces the need for a sizable portfolio of investments if you are an angel or fund investing as a first check, pre-seed, or seed stage investor as well as the perspective that this is a possible path. If you aspire to angel invest, please pick more than one company and build a broad portfolio. Please.

As an early stage investor, you just cannot control what is happening positively or negatively to you in subsequent rounds especially if the company loses its leverage to dictate the terms of a financing. Yes, a board seat can put you closer to the decision but boards can and often do get re-defined with each round of funding.

With so many lofty valuations and ridiculous funding rounds being done these days in “hot” companies, I can only wonder what the preference stacks look like in those companies. A relatively newish fund manager I was chatting with recently who had a few of those hot names in their portfolio had no idea what the preference stack was or how it worked. It made me feel for him and, more importantly, his LPs.

It won’t matter if it all goes well but if it doesn’t, even for a short period of time, watch out below.