Is Common Stock the Ideal Security-Type for Equity Crowdfunding?

What is Common Stock?

Common Stock essentially represents ownership in a company. Investors receive common stock in exchange for their investment. Through the ownership of common shares, they become part owners of the company. The percentage of ownership stake is in proportion to the number of common shares owned and sometimes bring with them voting rights.

History

Perhaps because of their experience with the stock market (where common stock reigns supreme as well), common stock has remained one of the securities of choice for equity crowdfunding investing. The primary reason had been the understanding of common shares from the public market. However, investors that receive common stock in exchange for their investment do not often get voting rights as they do in a public company.

With the changing times, there are numerous other options available regarding security instruments issued in exchange for investment. Common stock is no longer the automatic security of choice. The most significant deterrent is the fact that common stock lacks several rights, preferences, and protections that the early-stage investors should receive considering the risk is assumed by them by investing in an early-stage company.

Food for Thought

Common stock is last in line to be paid in case of liquidations events like the sale of the company. Also, if the business does not turn out as successful as expected, common stockholders do not have the liquidation preference. Common stock holders are last in the pecking order. Preference is always given to the debt holders and preferred stockholders. Often, should the worst happen, there’s nothing left.

In addition to the obvious drawbacks, the advantages associated with holding common stock can be of value. With convertible notes and SAFEs, there can often be ways for investors to be paid off based on the terms of the “loan,” which is technically what those securities are.

In the event that a company sells for 10 or 100X, sometimes SAFE holders can simply be paid back with interest (6 to 11%) instead of receiving equity and sharing in the upside. The other benefit of common shares has to do with the fact that startups are required to actually price the round. In other words, they go through an exercise of actually valuing their company rather than pushing this off to the future.

By taking this approach, often startups raising via common shares will have more reasonable valuations in comparison to SAFEs and convertible notes. Additionally, as secondary markets arise that will allow you to transact and sell shares of startups, common shares will provide the most practical way to sell. Other securities may be challenging to sell in the secondary market.

They can also provide ownership rights and voting rights (sometimes). However, crowdfunding investors will almost always hold a small number of shares and the stake will not be enough to provide them majority rights. The decision making will still rest with the owners and other majority stockholders.

Though common shares technically can provide dividends, when it comes to startups don’t expect to receive any. It’s rare that this occurs.

Therefore, investors in equity crowdfunding must analyze all the available options before deciding on which security instrument to invest in.

Bottom Line

In our experience, the answer as to whether common stock is a good idea as compared to, say, preferred stock, depends on the details. What you don’t want to do is sacrifice security and voting rights for upside. That’s the reason to invest in early-stage companies in the first place. Preferred stock that converts to equity at a high valuation could very well lead to a mediocre return.

Lastly, it bears repeating that investors must exercise due diligence and caution while investing in startups and early-stage companies. This is to ensure that your investment is aligned with your risk-reward appetite.