Except that it almost never actually goes that way. Instead what you get is .5% of a $5M company which has a $3M preference for the latest investor, leaving you with .5% of $2M, or exactly the same thing. Except more complicated than that.

That would be uncommon in my experience. Investors won't get the difference between the current and the last valuation as a liquidation preference, they'll typically demand one as high as their investment. Understandably, they don't want to throw in a million, get 20% of the company only to have the company disband and receive 20% of the $1m back.

The $5m won't come from a $3m investment, though. They'll take 20% for $1m, leading to a $5m valuation. And I don't know anyone that would give them a $3m liquidation preference in that deal. If your cash-on-paper (that is: shares vs total valuation) share doesn't grow in a round, that's a good time to think about getting out. If they were valued at $5m and are seeking investments valuing the company at $2m, run.

Yes, investors aren't throwing money around like they maybe used to, but I don't believe there's reason to be overly pessimistic. If the company becomes successful, you'll make money if you've been on board early enough (that is: if you took on risk).

Why would investors go for that? In case of no investment, the company goes under, so you get 1% of $0. Therefore, you should be happy with pretty much any kind of dilution, new investors can easily force existing shareholders to get e.g. 0.1% of $5m.

That's why you don't speak to one investor only. Investors want to invest to make money and they compete against each other (if the company is interesting). Yes, if the situation is "please give us money or we're dead tomorrow", the negotiation position is going to be bad, but that would be because of mistakes made earlier (i.e. not talking to multiple investors, not talking to them early enough, not understanding when the money is going to run out etc).