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.
It may be sensible for the founders and investors, but is it sensible for the employees? Many startup employees are paid to a significant extent in stock and do not understand the situation they end up in. They are also powerless and just have to trust that the founders and investors will treat them well.
Rationally, this leads to many of the best people ignoring the startup world
VCs really don't care about "sweat equity" or "discounted salary equity". They believe that if you don't bring actual cash to the table then you aren't risking as much as them (even though they are only putting their clients money, not their personal money in most cases).
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).
I was the third employee at a startup. I was young and stupid and thought "20,000 shares" was a lot. I worked my ass off, it was immensely stressful, but we built and launched a product. I later found out it wasn't much of a stake at all- .1% and that's even before any dilution shenanigans and all that. We took a paycut part of the way through, had our 401k contributions slashed and such.
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.
+1 I initially learned this lesson on the other side of, when was part of a startup during college. I was putting in long hours alongside my co-founder, but my staff were doing merely an adequate job.
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.
I was the third "employee" at an internet startup (maybe the fourth, I forget) after the CEO and the lead tech guy, and I got...$5/hr as a 1099 consultant. That's actually more like $8 in today's money. I just looked it up and it was the same year eBay (AuctionWeb) was founded. Coincidentally my boss asked me to (with hindsight) basically create eBay and I didn't have a clue where to start or the necessary hubris. After that, they figured I wasn't useful as a programmer (I was hired to answer the phones).
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.
That's equity compensation, in my view. It's not like it's different at the FAANGs. If you go to work at Apple, and you work super hard, and the company declines in stock value from $5jillion to $3jillion, nobody is like, "Whaaaat? Why didn't my equity go up in price? I worked really hard, and also $3jillion is still a ton of money!"
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.
Definitely agree that equity compensation carries risk.
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 have no knowledge of the startup world, but based on the article, if both the founder and employees have common shares then their incentives are aligned (i.e. the founder wouldn't want to sell the company unless the price was well above the preference overhang). Of course, deception can pay a role in making this less fair.
The article mentions at least one reason why the incentives often aren't aligned: a carve-out agreement that guarantees specific people (often founders) a cut from the "preferred" part of the pie. As I understood it, this cut is completely unrelated to the amount of shares (common or otherwise) those people own and is a separate agreement saying that they get eg. 10% of the money in the event of a sale.
Carve-outs in general are mentioned in the article. A common type of carve-out: the employee retention pool. The article does not say that founder carve-outs are common. I'm sure they've happened, but you said they happen "often", as a way to get founders to greenlight deals. Do you know how often that happens?
Use a lock-up (like public markets) or have the preferences expire / reduce (like the contracts some banks gave pre-IPO Uber employees). Or be like Softbank and demand a 7% dividend on invested capital. Or if you don’t actually have a constructive relationship with the founders, don’t invest.
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.
Yep. They're locking in their upside to offset for the risk they see in putting in $5 million. 3x preferred is either a weak founder with a good company or more likely an ok founder desperate for funding and therefore pretty high risk for the investor.
