When institutional investors put money into companies backed by venture capital, they typically end up owning a type of stock called preferred shares. Now, institutional investors are also becoming owners of a different class of start-up stock: common shares.
The competition among investors to get into hot start-ups has been so fierce that many hedge funds, sovereign wealth funds and others have been unable to participate when the up-and-coming companies sold preferred shares, a kind of stock that generally comes with many protections.
So to make sure they got a stake in private companies like Palantir Technologies, Dropbox and One Kings Lane, the institutional investors instead began buying common stock — generally owned by employees of start-ups — often from workers directly or from platforms that sell employee shares.
In doing so, the investors chose to forgo the protections that come with preferred shares. Common stock usually comes with no guarantees and is paid out only after the preferred shareholders get their money.
The trend has gained steam in recent years. Firms that buy employee shares, like Equidate and EquityZen, have proliferated in the past few years, competing with established firms like VSL Partners and Millennium Technology Value Partners. These firms have collected employee equity from scores of start-ups including Airbnb, Spotify, Pinterest, Dropbox and Palantir, according to their websites. In some cases, they hold the shares in their own funds, and in others they act as brokers who get the stock to hedge funds, family offices and investment firms in Asia and the Middle East.
The spreading of common stock may have some unintended consequences, especially as the air begins to come out of the Silicon Valley boom and some companies get sold for modest amounts of money. For one, institutional investors who own common stock could take home much less than other investors in the same company who have preferred shares. That gap, in turn, could lead to more litigation between investors.
The gulf between what preferred and common shareholders are paid has already led to an increase in shareholder versus shareholder litigation over the past two years, said Patrick Gibbs, a partner at the law firm Latham & Watkins in Menlo Park, Calif., without providing examples.
In most cases, preferred shareholders walk away with rewards, or at least with much of their money back. For common stockholders, however, companies must sell for a relatively high price or have a successful public offering for common stock to be worth much of anything, said Nizar Tarhuni, an analyst at the data company PitchBook.
The interests of the common and preferred shareholders are often not aligned, especially when investors who hold preferred stock want to get their money out, said Dennis White, a partner at the law firm Verrill Dana.
“Preferred shareholders have rights that let them time a sale of a company, even if it’s not at a time when they can get a deal done that pays common shareholders, too,” he said.
Professional investors owning more common stock puts a new twist on this dynamic, said James Hutchinson, at law firm Goodwin Procter. “It’s a totally new world when sophisticated, well-heeled investors own a lot of common stock,” he said. “Individuals often don’t sue, but institutions budget for litigation. They are more motivated to sue.”
That happened in the case of Good Technology, a mobile-security company that was sold to mobile software and device maker BlackBerry for $425 million in September, far less than its last private valuation of $1.1 billion. Employees and other common shareholders, including family offices and institutional investors, received about 44 cents a share. The venture investors on the board got more than $3 a share.
Employees have not sued Good, which is based in Sunnyvale, Calif. But Good’s former chief executive Brian Bogosian, a significant shareholder of common stock, teamed up with two venture firms, Harvest Growth Capital and Saturn Partners, which both acquired common stock, to sue most of the board in October. In their complaint, the plaintiffs said that they want the suit to be recognized as a class action.
Mr. Bogosian and the funds allege that Good’s board breached its fiduciary duty by only considering the needs of preferred shareholders when doing the deal with BlackBerry. Good, they alleged, was sold to BlackBerry because the venture investors chose to get the protections they knew they would reap in a sale instead of the uncertainty of raising more money or going public and seeing their stock potentially lose value.
Latham & Watkins’ Mr. Gibbs is representing Good’s board and Good’s then-chief executive, Christy Wyatt, in the case. In a legal filing, he called the suit a case of “Monday morning quarterbacking.”
BlackBerry did not respond to requests for comment. Randall Baron, an attorney who is representing the plaintiffs, said: “The decision to sell to BlackBerry for woefully inadequate consideration was clearly self-interested” on the part of the board and management.
Shareholder versus shareholder suits in tech start-ups have occurred in the past. In the aftermath of the late 1990s dot-com boom, common shareholders sued preferred stockholders, said Mr. White.
In 2005, a suit was also brought by common shareholders against directors of a translation software company called Trados, he said. In that case, the common shareholders got nothing and the preferred shareholders got most of the money from a sale. Common shareholders lost the Trados case largely because the judge ruled that the company wasn’t worth enough in the end for a larger payout. But Mr. White said the case was a wake-up call for that generation of dealmakers.
“It raises the question about where your duties lie if you’re a venture capitalist and a director,” Mr. White said. “Your duty is to represent all shareholders, and that can conflict with your duty to the folks who invested in your fund. This is an area where inside investors have to tread carefully.”