Normally the way the preference works is that you "give up" your shares in exchange for being paid back, as if you had initially given the company a loan instead of bought equity.
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, 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.
Why moralize? It may be that there's nothing intrinsically unconscionable about it; it could just be a way of expressing the market power the investor and the company had when the funding deal was struck. You could similarly say a harsh down-round is unconscionable (a low valuation can just as easily wipe out returns for employees), but we tend not to think companies taking down-rounds are "unconscionable" so much as they are "distressed".
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?
It seems perfectly valid to "moralize" (that word sure has some baggage, doesn't it?) about those who have power exercising it at the expense of those who don't. In fact, I'd expressly encourage it.
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".
In the general case, when it comes to startup financing, isn't the "power" we're referring to is market or bargaining power? Venture firms compete with each other for access to viable startups. If the terms being offered to a startup include >1x or participating preferences, that says something either about the negotiating competence of the startup or about its underlying value.
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.
Isn't pretty much every interaction humans have with each other outside of close friends and family (and even within, to some extent) driven by market forces and/or bargaining power in some way? Some larger examples I can think of off the top of my head are the ballooning costs of healthcare in America today and the trans-Atlantic slave trade.
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.
