Back in the Cro-Magnon era (prior to the dotcom meltdown) angels were not only enthusiastic to invest, but in many cases they were willing to purchase common stock, foregoing the VCs' typical investment contract ... liquidation preference, dilution protection, dividends factored into the conversion formula and participating preferred. However, with the scarcity of angel capital plaguing the business today, the times 'they are a-changing.' Those angels who are willing to play in today's climate (and they are a scarce resource), are acting as if they were participating in a Series A Round. They want the same protections the VCs are accustomed to getting.
The argument against the angels' position is that a participating preferred stock (with all the bells and whistles) at the angel stage complicates the balance sheet and makes it that much harder for the company to raise the Series A Round from VCs, when the time comes. Venture capital is a chancy and fragile business and anything which makes financing harder to find can be self-defeating. However, the angels are entitled to respond: "Tell that to the Series A investors; the special rights they bargain for often make it difficult to raise the Series B Round and yet nobody is arguing that the Series A investors should take common stock."
The fact is that the later round investors have a remedy in today's environment ... the Golden Rule ('He who has the gold makes the rules'). Thus, the incipient Series A investors can say to the angels (and the Series B to the Series A; the Series C to the Series A and the Series B etc.): "Get rid of these special rights or else we will not invest." However, as I have noted before (see "The Overhang Problem"), there is always the possibility that the Golden Rule may not work, due to the existence of blocking positions enjoyed (depending on the documents), by a malcontent, disgruntled investor. It may be contractually impossible to clear the decks of awkward provisions in order to satisfy the new investors. The disgruntled investor may hold out either for an enormous special payment (the 'dog in the manger' ploy) or may, in some cases, be perfectly willing to see the company tank, if he or she is angry with the incumbent management for some reason.
The sum and substance of all this is as follows: The angels are going to get VC rights in today's environment, and perhaps from here on in. This can, indeed, create awkwardness when the Series A round is being solicited. But, the angels are, I predict, going to be insistent. The threat of them being washed out, absent anti-dilution protection or pre-emptive rights for example, is too significant for them to 'play' without those special protections. Accordingly, it is up to the company's counsel to keep a very careful eye on the provisions that will prevent one disgruntled holder from, in effect, destroying the ability of the company to finance in future rounds. This can include 'pay-or-play' provisions or empowering a majority (or supermajority) of the existing round to make, on behalf of all the players, the necessary concessions.
In subsequent Buzzes, I plan to come back to the issue of multiple liquidation preferences, which are now a fact of life in private equity finance. My colleague at Morrison & Foerster, Tim Harris, has already dealt with one of the dangerous features of multiple series of preferred stock in his article on the infinite regress problem which serial anti-dilution protections can create ... the Series A anti-dilution protection is triggered by a down round which, in turn, triggers the Series B provisions, which then energize the Series A all over again, which in turn activate the Series B, etc., etc., etc. Tim, a student of this game, will also have something to say in a future Buzz (and in much more elegant and complete form in The VC Encyclopedia) on the question of when preferred shareholders should convert to common stock, an issue he has previewed in a piece in The Daily Deal, Sept. 16, 2002.