Bad VC Behavior: Chucking the angel preemptive right by Charles Korsmo

In the US VCs tend to favor preferred stock over common and debt. Some reasons for that are their ability to negotiate ad hoc details regarding their ownership and involvement (since they tend to prefer being active investors) and because it affords the company some tax advantages that lower costs of employment.

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VCs and preferred stock, VC investments

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Why do VCs hold preferred stock?

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  • The fact that VCs tend to hold preferred stock can create some conflict between them and different common stockholders
  • One upside of preferred stock is that it can be contractually structured ad hoc to fit the needs of each VC (especially through rights and protections)
    • In the US VCs tend to receive convertible preferred with liquidation preference
      • Meaning it can be converted in common in the future
      • And that in case of a liquidation, the preferred stockholder will receive a specified amount before the common holders receive anything
        • This makes the instrument look more like fixed income/debt than equity
    • Another reason could be tax advantages for the company in the US
      • If the IRS lacks a benchmark to evaluate common (what VCs paid for it), it must rely on company valuation of common to tax it as income when it is awarded as compensation to employees
    • VCs favor preferred stock over debt because they often want an active role in governance and management of the company
  • Preferred affords greater leverage, greater control, protection for the investors, and tax benefits and lower compensation costs for the company
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