Ask HN: Why is liquidation preference acceptable and prevalent?

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.

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.

> 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.

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.

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.