50 Questions: What are the different types of instruments VCs use to invest?

Thirty third in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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You won’t be surprised to hear that VCs don’t use banjos, guitars or any other musical instrument to invest, rather we use ‘investment instruments’.  Investopedia defines an investment instrument (aka a financing instrument) as “A real or virtual document representing a legal agreement involving some sort of monetary value. In today’s financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset.”

Put slightly differently investment instruments are legal documents which determine how much an investor invests and how much they should get back, when, and under what circumstances.  Each one is individually negotiated, but they can be grouped into categories.

The vast majority of VC investments are in one of three categories of investment instrument:

Very occasionally you will also see VCs make investments in straight forward debt (i.e. with no conversion rights, see below), but this is rare and I won’t go into detail here.

In the remainder of this post I will describe the most common types of preferred share, ordinary share and convertible debt investment, but as noted above each deal is uniquely negotiated and there are an infinite number of possible variations, but I will keep it simple and not describe many of them here.

Preferred shares are the favoured option of most VCs.  They operate as shares in the company, in that they give the holder ownership over a portion of the company and a share in the proceeds of any exit, but they have extra rights on top.  These rights typically give the investor some or all of, more money on exit than straight forward ordinary shares, more control over the company, and assurance that they will receive regular information about the development of the company.  See my previous posts on key clauses in termsheets for more detail on these rights (Part 1 and Part 2).

Most VCs like to invest in preferred shares when they can because they typically provide better returns for a given valuation and they give some protection in the downside scenario where the entrepreneur radically changes their plan and pays no heed to the interests of the VC – e.g. by running a lifestyle business with no intention to exit.  This protection is important because most VC investments are for a minority stake.

Hot companies that are being chased by all the VCs are sometimes able to insist that the investment is in ordinary shares.  These shares give the investor similar benefits to preferred shares in upside scenarios but offer much less in downside scenarios, and for this reason are often regarded as better by entrepreneurs, particularly those who don’t really trust VCs.  I would argue that if trust is absent the basis for a good ongoing relationship is also absent, and both parties should think hard about whether they should be going into business together.

There is a common confusion in terminology that is worth noting.  The most important difference between ordinary shares and preferred shares is that preferred shares typically get more money on exit, at least in some scenarios (again see my term sheet posts for more details) and for this reason sometimes shares that are technically preferred shares and have extra control and information rights, but no extra economic rights get referred to as investments in ordinary shares or ‘ords’.

The third common instrument for VCs is convertible debt.  In this scenario the investor makes a loan to the company, typically complete with an interest rate and a repayment date, but crucially it is expected that rather than being repaid the loan will convert into equity when the company raises its next round.  When a loan converts it is as if the loan holder invests cash at the time of the conversion and the loan instrument is replaced by the instrument of the round, typically preferred shares or ordinary shares.  The valuation for the company and hence the share price is set by the new investor, but the conversion terms usually say that the loan holders get a discount to compensate them for the extra risk of investing earlier.  A discount of 20-30% is typical.

Convertible loans are common in two situations:

  • In seed investments where the price of the company is very hard to establish, in this situation a maximum valuation for conversion (a cap) is typically agreed.  The advisability of using convertible debt for seed investments is hotly debated (see the related articles below).
  • When a company runs out of money and its existing investors want to give it a little extra runway so it can achieve some value milestones and raise money from a new investor.
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  • Anonymous

    Interesting what you’re saying about trust. I don’t understand it though.

    You imply that an entrepreneur asking for the VC to have ordinary shares doesn’t trust the VC. Why so? Surely they are simply negotiating that they lose less money in downside cases such as breakeven on exit (perhaps because they know they’ll then want to start another startup!).

    I don’t get why that means they trust the VC less. It is asking the VC to trust them more, but as you say, trust is vital to the relationship!

  • You may have caught me out with a one-sided perspective 🙂

    I didn’t mean to imply a causal relationship, rather that I have observed a correlation between distrust and the importance placed on not giving investors ordinary shares.
    The handshake deal is usually that there is some sharing of control and pref shares put that in writing. A reluctance to do so either indicates a concern that the control might be abused (lack of trust) or a desire to not give up any control.
    Note that I am focused purely on the issue of control. Economics are different, and are purely about negotiation, as you say.
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  • Anonymous

    Makes sense – this discussion has taught me to make sure control and economic aspects of types of share are handled clearly and separately.

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  • From a tax perspective which is better for the VC investors? (Uk vs USA) ?

  • Tax isn’t a big driver for most VC investors.

  • ☺ you can guess what I’m thinking now….