“Back in the day” (late 1999) I was a part of an investor group that contributed $1 million for a 35 percent ownership stake in a startup technology venture that held a lot of promise (don’t they all?). You can probably guess the next chapter in this story. The tech bubble burst, the NASDAQ dropped 65 percent, technology needs shifted quickly and our company’s outlook changed dramatically within about a year.
Fortunately, we had a great investment banker who was able to arrange a sale of the company and its technology to a public company out of Canada for $1.5 million USD. Our 35 percent equity stake in the company would return only $525,000 of our initial investment, a 50 percent haircut in less than 18 months. Ouch!
That’s when I first learned about, and fell in love with, the concept of an investor preference. Since then it has been a required part of any private investment I participate in. You will require the same after reading further.
Because of our “preference,” we were entitled to the first $1 million of proceeds from the company sale and 35 percent of everything over and above our initial investment. We realized $1.175 million of the $1.5 million net proceeds and were the only investors to earn a positive return on our investment in the company.
Given the difficult angel investment environment today, a preference is almost required from savvy investors. The limitations of your preference are what the company will accept, and whatever you feel is reasonable protection for the risk you are taking with your investment capital. Here are some fairly common examples:
- 100 percent preference and 10 percent annualized return from time of investment
- 100 percent preference and proportional share of additional proceeds (stated above)
- 200 percent preference on investment amount
- Full preference with an equity kicker if company has not been sold within 5 years
An investor preference is limited only by your creativity and imagination. It is also a wonderful opportunity for entrepreneurs to create an offering that is more attractive to initial investors. With early investors, a preference is a great way to reflect management’s confidence in (and fairness towards) future prospects for the company.
Raising angel money is a very difficult task. A well-constructed investor preference can help minimize investor risk in a creative way that helps attract startup funding. There are a lot of variations, complications and opportunities when creating an investor preference, so be sure to do your homework and think through the implications for future financing rounds.