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Ask HN: Why is liquidation preference acceptable and prevalent?

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Re: Ask HN: Why is liquidation preference acceptable and prevalent?

#11

Post by eldavido »

AnotherMarc wrote: post #8

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.

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.

Re: Ask HN: Why is liquidation preference acceptable and prevalent?

#12

Post by eldavido »

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.

Re: Ask HN: Why is liquidation preference acceptable and prevalent?

#13

Post by philrapo »

auganov wrote: post #3

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…

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.

Re: Ask HN: Why is liquidation preference acceptable and prevalent?

#14

Post by philrapo »

dragonwriter wrote: post #5

> 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 (…

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.

Re: Ask HN: Why is liquidation preference acceptable and prevalent?

#15

Post by auganov »

philrapo wrote: post #13
auganov wrote: post #3

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…

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.

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

Re: Ask HN: Why is liquidation preference acceptable and prevalent?

#16

Post by rahimnathwani »

auganov wrote: post #3

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…

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.
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