Ask HN: Why is liquidation preference acceptable and prevalent?

https://news.ycombinator.com/item?id=9036407

by philrapo • 11 years ago

8 14 11 years ago

news.ycombinator.com

It seems commonly accepted that all VC investment comes with (at least) a 1x liquidation preference. Is there logic as to why this is commonly accepted and prevalent? Clearly investors always want the best possible deal for themselves, but why/how did this become the standard deal term? On the surface, it seems wrong that employees get "worse" equity, i.e. common equity, than the investors and founders.

Why shouldn't investors and founders share the same equity as other employees? Investors can presumably adjust their valuation model accordingly.

auganov2• 11 years ago

The most common argument for VC 1x liquidation preference is to avoid the situation where the VC looses while the founder gets rich. Say the VC puts in 5M, gets 20% equity. The founder sells for 5M, gets 4M, big success for the founder, total failure for the VC.

Now the counter argument would be that whether its a 0x or a 1x it's a loss for the VC, as they're in the game of getting a 100x. And the founder's 'win' is only a win relative to the general population, they also lost as they could have made so much more if things went right.

So 1x liquidation is mostly to prevent a founder from trying to game the system. But I can totally see how it could feel unfair if there wasn't any ill behavior founder-side.

The issue of employee stock [options] vs founder stock is a somewhat separate issue.

philrapo2• 11 years ago

Thanks.

It would seem like a 0x liquidation preference would provide protection in this scenario. i.e. VC is guaranteed to get his original investment back, but not a multiple of it.

"Say the VC puts in 5M, gets 20% equity. The founder sells for 5M"

VC could just get the 5M back in this case.

auganov2• 11 years ago

This is exactly what 1x non-participating liquidation preference is. The 1x is 1x of the invested amount, not a profit multiplier. https://vcexperts.com/buzz_articles/185

rahimnathwani• 11 years ago

Exactly this. Say I raise 1m of VC money for 20% of my company. I could sell the company tomorrow for 1m (as I own 80% and have majority voting rights), and get to keep 800k without doing anything. The VC would lose 80% of their investment in a single day.

Zigurd• 11 years ago

What else are you going to do when you are at round X, when the original investment could be considered a lost cause? You could sell the assets into a new venture. I've seen that done. Then the original investors take the asset sale revenue, lick their wounds, and move on.

Or, if new investors give a new investor a liquidation preference, they could ride along with an outside chance of seeing some upside. In that light, an investor with a liquidation preference is preferable to an asset sale.

dragonwriter• 11 years ago

It seems commonly accepted that all VC investment comes with (at least) a 1x liquidation preference. Is there logic as to why this is commonly accepted and prevalent?

Liquidation preference in effect makes VC investment a hybrid between standard equity investment and a loan (it has an almost-guaranteed repayment feature, like a loan, but trades interest for potential upside.) Its better for the other stockholders (and for the success of the company) than VCs holding debt instruments, and its better for the VCs than common stock.

On the surface, it seems wrong that employees get "worse" equity, i.e. common equity, than the investors and founders.

As long as the features of the type of equity they are receiving are taking into account when employees decide to accept an equity + salary compensation offer, I don't see the problem. Liquidation preference is a guarantee against losing money. The employees' guarantee against losing value for the time invested is the salary + benefits part of the salary + benefits + equity pay deal.

philrapo2• 11 years ago

That's an interesting way of framing it. A 1x liquidation preference is like buying a loan at 0.50 on the dollar.

A 0x liquidation preference (insurance that you'll get your original investment back) would be more "bond-like" to me.

Good point that the employee can similarly adjust his/her price on the compensation offer. Unfortunately, I think a lot of employees in SV dont understand the dynamics at hand here.

If you are an early employee, it's also not possible to know if the company will accept a 2x liquidation pref investor in the future.

Eridrus• 11 years ago

To the extent that startups are swinging for the fences, everyone should be well aligned (0.5% isn't much unless the total is pretty huge), since you're trying to optimise for the extreme outcome, rather than "average", having such a clause could let you benefit in other dimensions that help you towards your goal.

I'm speaking in generalities since I'm not sure about specifics, but as an example an investor might be willing to accept a smaller (i.e. less controlling) stake with liquidation preferences for the same price, which leaves you more equity to sell to others.

brianchu• 11 years ago

Here's the argument I've heard: Let's say you found a company. A VC invests $1M for 20% of the company, for a $5M post-money valuation. Then you immediately sell the company for $3M (less than $5M). You make $2.4M. The VC essentially loses $400k. The 1x liquidation preference protects them from losing that $400k.

hawkice• 11 years ago

It's also worth pointing out that >1x liquidation preferences make a similar type of sense: if the VC invests $1MM for a post-money valuation of $5MM, and is handed the $1MM back two days later while the owner pockets $2MM, that's not really respectful of their time. It would probably be okay to limit the liquidation preferences at 1x and rely on professionalism, but higher multiples aren't an outrageous ask most of the time (the investor and the founder(s) should have similar outlooks for the future of the company) and it's a pretty easy thing to put in during negotiation.

AnotherMarc• 11 years ago

From a preference standpoint, I had assumed that founders were in the same boat as employees most of the time (especially first-time founders), just that they have a lot more stock.

If investors put in $10M and the company sells for $9M, doesn't it all go to the investors?

If founders get the same preference as investors, it wouldn't be true. I just didn't think they normally did.

eldavido2• 11 years ago

Your understanding is correct, founder shares are typically just common, the same as employees get, whereas a lot of early-stage capital partners (investors) get a different class of stock with a preference attached.

OTOH founders typically have much larger interests in the companies they own, leading to much higher control, which is for all intents and purposes a different class of stock, even though the rights of say, an employee, are nominally the same. Control is everything.

Also, P.S. most employees get options, not shares, which can be exercised into common shares, but are a little different with regard to tax and the fact that they must be "purchased" or exercised.

avemuri• 11 years ago

It's downside protection. It's basically saying they get paid before the founders but after loan holders. I'm simplifying, since multiple and/or participating liquidation preference does alter the math, but roughly speaking that's it.

On common stock though, I don't think that'll fly. There are a number of ways where founders with board control can screw a minority shareholder. For eg. they can issue 10x the current outstanding shares to their family, or appoint their friends to the board, or sell the company, or sell the company. It's only in extreme cases that VC's will expose themselves like that. I believe facebook's first institutional round was for common stock and no board seat.

eldavido2• 11 years ago

To answer your question: I don't know. But I imagine if it became common not to have, valuations would be adjusted accordingly to price in the risk.

Which makes me wonder, if a company raises $1mil (1 million shares, $1/share) @ $9mil pre-money, that means the investors get 10% or, say, 1mil/10mil shares. But is it really fair to extrapolate that 10% ownership for $1mil means the whole thing is worth $10mil, given the significantly different provisions (ratcheted anti-dilution, pro rata/drag along rights, information rights, liquidation preference) their shares tend to have over common?

Maybe the SV convention of treating all shares as equal when talking about valuations should be examined more closely.

Ask HN: Why is liquidation preference acceptable and prevalent?

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