Reason #5 for Seats: Much better for angels



This post is for the angels and small VC funds who buy passive, minority equity interests in start-up companies. Seats are a much better form of investment for you. Consider the following:

No free lunch

When you buy equity in a start-up company you pay for everything you get. You pay for the voting rights. You pay for the liquidation preference.  And you pay for every other possible economic outcome of the company except insolvency. This is the heart of the problem – you may not want these things, but you must pay for them.

Let’s consider what you are buying.   

Voting rights

Why does as a passive minority investor need to vote? It’s the protective voting provisions that are important. You need to be able to protect yourself against actions that may be taken by the majority that are not in your best interest. But this is only necessary because you bought equity in the first place. The cost of the vote for a passive minority investor is an insurance premium that you must pay to protect your equity interest. 

Economics

Some people may think that equity is the only way to get the upside returns of a company, but equity can actually lower returns versus a pure play position on revenue, such as Seats.  This is because when you buy equity you pay for the upside as well as all the other low-rate returns you may earn. This is especially true when you receive a liquidation preference, which means you are buying downside protection.  If you didn’t have to buy all these possible low-rate returns, you could focus your total investment on the true upside scenarios.      

Big clumsy ownership

So why do equity investors have to pay for terms that they don’t want?  It’s because of the nature of equity.  Equity is meant to represent ownership.  As a contractual and practical matter, it is very difficult to slice up ownership in different ways among a large group of investors. You end up having to provide for complicated voting structures and convoluted contractual provisions that attempt to account for every possible outcome.  The more investors and the more variations, the bigger the problem.  For this reason, the preference is to give everyone the same thing and to limit the number of investors as much as possible.

But why do passive minority investors need ownership?  As explained above, it’s not for the vote or upside returns. So why ownership?  Why equity? 

A better way

We believe that it would be better for many start-ups if equity ownership were limited to a small group of active investors, allowing passive investors to invest via Seats. 

This capital structure would be better for everyone.  It would greatly simplify the ownership structure of the company and systematically improve the economics to the passive investors because they would be able to buy only the positions they want.

Also see related posts: #10 Reason for Seats: Investors pick their spots and #9 Reason for Seats: Owners stay Owners

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