A few years ago I was a part of an investor group that contributed $1 million (35% ownership stake) to a start up venture that held a lot of promise (don’t they all). Market events, competition and technology evolution changed our company's outlook within about a year.
Fortunately we had an investment banker who was able to arrange for the sale of the company and its technology to a public company out of Canada for $1.5 million (US) dollars. Our 35% ownership interest would provide a return of only $525,000 from our initial investment, a 50% haircut in less than 18 months – Ouch!
That's when I first learned about, and fell in love with, the concept of investor preference.
Because of our “preference,” our group got 100% of first million of sale proceeds AND 35% of everything over and above that. We realized $1,175,000 of the $1.5 million and were the only investors to earn a positive return on our investment in the company.
Since then, I’ve required a preference in every investment I participate in — and have seen — many variations of the preference:
100% preference and 10% return from time of investment
100% preference and proportional share of additional proceeds
200% preference on investment amount
Preference with a kicker if company has not been sold within 5 years
An investor preference is only limited by your creativity and imagination. It is also a wonderful opportunity for entrepreneurs to create an offering that is more attractive to initial investors.
There are a lot of variations, complications and opportunities when creating a preference in your initial investment or equity raise. Like all powerful tools, please use caution when operating.