Fortunately we had a violent restructure and an insane cap table got crunched down, cleaned up and all that stuff was made null and void. Definitely a "useful crisis" as we got to an exit later without any liquidity prefs hanging over our head.

E.g., you invest $1M, company sells for $15M, and you want to be able to get $2M (2x) of the $15M in exchange for your investment.

With regular preferred shares, you get paid your $2M and then that's it, your initial $1M is paid back.

With participating preferred, you get your $2M, but then act as if you still had the equity that you bought with the $1M (even though you basically already got paid back for it). So you get $2M + whatever your cut of the remaining $13M is.

I invest $100 for 20% of your venture. You sell for $200.

Standard preference: I get $100, not $40, as my % would suggest, because I get at least every dollar I invested back.

2x preference: I get all $200, because I'm promised at least 2x my investment back.

Participating preferred: I get $120 (I think?) --- I first get my invested dollars back, and then I still get my % of the venture.

I invest $100 for 20% of your venture, implicitly valuing the company at $500 . You sell for $200.

- Standard preference: I get $100 or 20% of the company ($40)

- 2x preference: I get $200 or 20% ($40)

- Participating preferred: I get $100 and 20% of the company ($140)

IMO, 1x preference, non-preferred is entirely fair. In the event the company sells for lower than the valuation, the investors get their money back first. The vulnerability it protects against is that I found a company for $0, you invest $100 for 20%, then I immediately turn around and sell for $101. You get $20.25 and I get $79.75.

Participating preferred and >1x preference are unconscionable.

Founders don't like liquidation preferences for the same reason employees don't --- especially if the company limps to liquidity, which is probably the common case, as opposed to blowing the doors off things, in which case the prefs probably don't matter that much. They're incentivized not to accept high preferences; if they do accept them, isn't that just a sign that the company didn't have much bargaining power? Should the company not take the money under those circumstances, and RIF its team instead?

Not saying I'm particularly worried in this case, but overall I don't think that "argument" is a very convincing one if we're actually concerned with "doing the right thing".

Is it a moral issue if a startup isn't valuable enough to avoid punitive terms? Who's doing something wrong in that scenario?

Obviously, it's bad if founders conceal that predicament from employees. I agree with the prevailing sentiment that employees should be wary about taking equity compensation.

In the general hierarchy of victims I'm not too worried about exploited startup workers. As you say, it's obviously bad if founders deceive employees, but I'd add that there are degrees of deception and also that there's a whole culture built up around working at startups that seems to suck people in. Who benefits from that? Keep in mind that startup employees are selling themselves in the same market, with even less bargaining power than the founders looking for investment.

If America had a real social safety net and real regulations in place to protect workers, I'd say go nuts. I think market forces can be a great optimizer for efficiency, and we should embrace the core principles of economics because doing anything else is tantamount to sticking our heads in the sand. But we should not forget that people can get hurt, and/or have their full human potential dribbled away down the drain for somebody else's gain. I will keep saying those things are bad until I start saying nothing at all matters.

Liquidation preference of 1x (or lower) is just sensible alignment of investor and founder incentives. The investor wants to make sure that if they buy 20% of the company for $5M, the founders aren't now incented to take advantage of them (in an extreme example: the day after the fundraising, liquidating the company for its assets, taking home $4M themselves and handing the investor back $1M. In a less extreme example, selling the company (in toto) for $10M a year or two later).

Liquidation preference of higher than 1x is a whole different thing. It's, at its most benign, something kind of like a financial instrument a little more like debt than stock, trading a more-guaranteed return for a lower price, or at its most pernicious, basically an attempt to create false impressions of a company's value. If you sell stock with a x3 liquidation preference, that is deeply different, and conveys considerably less investor confidence, than selling the same stock at the same price with x1 liquidation preference, but the press releases get to not mention the preference.

Rationally, this leads to many of the best people ignoring the startup world

That's one reason I didn't have trouble bailing on a startup I helped start. We took in $1.5mm, did some things poorly (such is life but learned good lessons from them) and even with a path forward we would have still required some more investment (since we weren't profitable). Therefore I knew what the current liquidation preference was, I computed what another round's liquidation preference would add, and it became clear we'd have to sell at $30-50m just for me to start getting money.

The likelihood of that happening was small, and the feeling of being un-incentivized from selling at a respectable $20m made me realize the whole game was stupid and rigged. Now I work at a bank making almost 3x of what I made in hard cash (plus better benefits which equals hardware) and that extra money is giving me much better returns in my retirement and stock accounts, and a better quality of life (and less stress).

A company in the space (but doing something different) called and made me an offer for twice what I was making. I was the lead developer by that point, had my hands in every significant piece of code, understood how everything fit together and such, and was appalled when I found out that I had such a small piece of the total pie. I demanded more, like 20x more, and they made it sound like I was asking to sleep with their wives. Then they absolutely howled that I was screwing them over by leaving right at launch- they asked me to stay for 3 months, which I said sure- if you match my new salary plus a little more as a retention bonus and to make up for some of the paycut, and again they howled at how could I do this to them...

It was a painful lesson, but I learned something very important- Do not work like you are an owner if you are just an employee! I still to this day (this was 10 years ago now) feel very taken advantage of. I was working tons of late nights and weekends, was a super fanboy of the company, at one point I was going to buy us a company logo made out of Legos to hang on our wall, and now I just cringe at the thought.

There are so many ways to lose in the startup game, just so many, its really not worth playing anymore IMHO unless you are a founder or very early stage employee with material access to the financials and such.

For a while I was confused and unsure why they weren't also pulling long hours, but I eventually learned the lesson. I was working hard to protect my baby, while my staff were just seeking to gain some experience in a cool niche. I would either have to realign incentives for them to also feel compelled to pull long hours, or I'd have to recalibrate my expectations.

In retrospect, I'm not sure what took me so long to realize this, but I'm glad it happened relatively early on in my life. The first job I took out of college, I made sure to keep my effort in line with my compensation and investment in the company.

Yes, if the employees' future paychecks for the next few months is being funded by that VC check. If the options are (a) VC money - but can only get it with liquidation preference ... or (b) insist on no liquidation preference - and therefore no VC agrees which leads to bankruptcy ... the "sensible for employees" is a moot point because the constraints of limited runway mean the employees care more about steady paychecks rather than owning worthless stock of a bankrupt company. (E.g. Google's first employees' salaries were funded by $25 million VC money from Sequioa and KPCB because Google had near zero revenue. Yes, Sequioa & KPCB had liquidation preference but it was irrelevant to employees since they needed the paychecks.)

On the other hand, if payroll expenses can be funded by revenue and the VC check is optional, maybe not.

Equity compensation is about owning part of the COMPANY. If the company has destroyed value -- if it is now worth less than its bank account, with no company attached, was worth before any revenue -- then your equity is valueless.

Asking for the reward of equity with no risk is weird.

However, I've seen equity pitched as a way to "make up" for the lower cash comp a startup might offer.

This is probably the wrong way to look at equity. The expected value of the equity might make up for lower cash comp, but that's with a large sample size. Employees don't get that benefit at all.

It's definitely up to the employee to understand the risks, but frequently they don't, and employers don't actively educate their employees.

I can only reason that it depends on whether the founder still has voting control of the company, but that's implied with "greenlighting".

WeWork is a similar situation where the founder is effectively getting a carve-out to greenlight the deal. That's only one example, though.

The only warrant for preferences is for fueling carry and information arbitrage within the VC circle. There is zero benefit to employees, who thankfully know more today.

If the company sells for $100M, the investor gets $20M off the top. My question: Does the investor still own 10% of the shares, and will they recoup $8M of the remaining $80M?

Is their $10M investment now worth $20M or $28M?

Non-participating: at liquidation, an investor chooses. They may either be paid back their investment (or more, if they have a multiple), OR they may choose to convert to common and get that percentage. They will, obviously, choose whichever pays them more =P

Participating is then also obvious: investors get their money (or negotiated multiple) out, and then get their ownership percentage of the remainder.

One thing that happens is companies very eager to raise monster rounds agree to shitty terms on all of the above. It's a lever founders and investors can manipulate to raise bigger rounds.

see eg https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidat...

So your answer: $28m. Because if you agreed to 2x preferences, you're raising on shit terms and the investor probably got participation as well.

Generally if you raise on good terms, you can get a 1x non-participating.

But it's good to know the details.

There is preferred stock (full price; i.e. investors) and common stock (incentive plans; i.e. founders/employees).

A liquidation employs one of two methods to distribute payment, depending on which is better for preferred shareholders:

* Method 1. Preferred stock is converted into common stock (usually 1:1). All common stock receives payment.

* Method 2. Preferred stock first receives payment according to liquidation preference which a multiple of the initial purchase value. Then participating preferred stock is converted into common stock (usually 1:1). Finally, all common stock receives the remainder of payment, if any. During preference, carveouts may protect certainly common shareholders.

In good exits, method 1 is used. In bad or mediocre exits method 2 is used.

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Liquidation preference and participation are not required, but are tools to give founders more money per investor share.

Nowadays, you should be able to get a solid valuation for 1x liquidation preference, non-participating, no carveouts.

IMO this is a sensible compromise; if you can't even keep the initial investment value, you really haven't done well anyway.

Liquidation preference is something that typically pays out once when an illiquid investment (private company stock) becomes liquid (IPO or sells).

They both share aspects in that you are investing money up front but they have different rules to how you get a return on that investment.