Comment by rlucas | Hacker News Reader

Comment by rlucas | Hacker News Reader

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> Tech employees need to wake up about common vs preferred shares, and that the former are worthless. > ... > They are worthless because they are designed, as a financial instrument, to be fake equity with no real protection from dilution and liquidation preference.

You've muddled orthogonal concepts together here.

1. Common shares are not worthless. In general, just ask any founder who's had a successful exit. Founder shares (unless purchased along side financial investors for hard cash) are always common shares; if your straw man were correct, then there would be no wealthy founders.

2. Liquidation preference is a negotiated term which does have a rational basis for existing. Whenever you're putting in a larger proportion of the company's cash than the ownership you're buying, it is crucial to have protection against someone essentially liquidating the company for the cash. Say investor X is putting in $8 into a company that has $2 in the bank, but X is only buying 10% of the company. If the company is liquidated for that $10 tomorrow, X gets back $1 and the common stockholders get $9. (There are other protections against a perverse liquidation incentive, too, but this is the economic one.)

3. The "real protection" from dilution is raising reasonable tranches of capital at a monotonically increasing series of valuations, which valuations actually correspond to a clearing price between bid and ask. Three key items here: "reasonable tranche," "monotonically increasing," and "clearing price."

a. Reasonable tranche: raise reasonable sized rounds, because huge rounds create weirdness (lopsided power, outsized compensatory "asks" by investors, etc.).

b. Monotonically increasing: needless to say, down rounds are the big dilution problems. Sometimes they happen because life isn't perfect and problems come up. Sometimes they happen because the company screwed up and raised too much at too high a valuation previously.

c. Clearing price: if the company and investor actually agree on the "true" valuation then it's easy. If they still try to force a deal where the company wants a crazy "optical" valuation that the investor doesn't really see, then you'll get layering-on of sweeteners to make the effective valuation much much lower than the notional, but all kinds of terrible side effects may accrue.

Thank you for the informative response.

1) Ok, Google/FB common shares were worth something. Those are extreme outliers in exits, and had ethical founders. But founders have another option if they drive the common share value to nothing - retention bonuses. They can say, ok we will make all the common shares worthless, but you can just give me a huge package as part of the aquisition. So employees can't rely on founders looking after common shares out of self-interest. If you read the article, it looks like that's extremely similar to what happened in this case.

2) All these financial experts can figure out a way to protect their necks without leaving the employees necks under the axe.

3) Real protection would also be voting rights, which generally preferred shares get a lot more of, and then less tangible things like invitation to board meetings, something mere employees accept is absurd to expect. As long as employees agree to sacrifice compensation while being told they're not investors and don't deserve to be treated like one, they're getting hoodwinked.

Let's do a thought experiment, you have a pie that you need to allocate, and you need to allocate it to the following groups.

Founders Investors Non-Founding Executives Non-Founding Employees

How do you allocate the pie fairly? How how do you ensure that risk is properly rewarded?

I have several friends and acquaintances whose exits as founders were in the $5-500 M gross exit value range -- far from a Google / FB outcome.

Those people all made an entire career's worth of money, or more, all at once* and with capital gains tax treatment to boot. (* well, after an earnout / lockup)

They also exclusively held common shares.

The deciding factor is whether their exit value was a meaningful multiple of the invested capital. If you raise $100 M and sell for $100 M then it's hardly fair to expect a windfall. If you raise $50k and sell for $5 M it's very fair to expect a meaningful personal outcome.

"> Tech employees need to wake up about common vs preferred shares"

The important distinction is employee vs founder. You mention founders in your comment.

Founders typically would hold a double-digit percentage of common shares.

Employees that might get offered 0.1% if they are an early hire, or less assuming later stage (discounting exec hires here, because the OP of this thread was about engineers).

Founders also typically got their common shares at a very low valuation - let's say they were issued pre-money, then their value to the tax man might be $200K (of a 2M pre-money valuation), but with a vesting schedule that makes them tax efficient.

Employees typically get their common shares at a higher valuation, post money, with a 200M valuation. Their 0.1% is also worth $200K to the tax man.

See how this is different?

You're exaggerating for dramatic effect. First of all, 1-2% is not uncommon for truly early employees. Second, it's quite typical for founders to work for free for a significant length of time to get the company off the ground. If the founders got the company to a 200M valuation with money in the bank to pay salaries, explain to me why employees deserve to be in the same order of magnitude shareholders as founders?

> 2) All these financial experts can figure out a way to protect their necks without leaving the employees necks under the axe.

Liquidation preferences are not the default in startup financing. They show up when money on better terms is not available.

Any management team is free to walk away from a term sheet that has liquidation preferences spelled out towards a term sheet that has VC buying common shares with no downside protection whatsoever, if such term sheet exists.

That all makes sense, but potential startup employees still need to be educated about the reality that common shares are much less likely to be worth much than preferred shares. Specifically, if a startup asks a potential employee to take a below-market salary with an option package -- which happens all the time -- the potential employee is best advised to value the option package at zero. The real reason, if there is one, to accept a below-market salary at a startup is intangible: experience and connections.

Edited to add: your item 1 overlooks the fact that founders hold a much larger piece of the company than any post-founding employee. An exit that makes a founder wealthy may do nothing more than compensate an employee for the salary difference.

> may do nothing more than compensate an employee for the salary difference.

if that.

of course this is HN so that's entirely reasonable because founding a company is a massive risk but being employee number 5 at a company that might go under in 3 months is fine.

I'm not well-versed enough in investment to reply to your comment on purely financial grounds, but I still see a problem -- how often are those steps actually taken in practice? How would it even be possible for an employee to know that the founders have taken (and will continue to take) responsible steps with their funding rounds?

Part of the issue at question is whether it's worth it for employees to bet on founders having done (and continuing to do) the right things with regards to investment. So when assessing the risk/reward of equity over cash, an employee now has to not only examine the marketability of a company's product and sales, but also whether they can trust the founders, board, or whoever to be responsible with equity dilution and valuations.

Given the huge variety of unknowns (and very high risk of dilution or lack of a liquidity event), as a non-startup-employed observer I have to say I'm very confused as to why startup employees take effective pay cuts for stocks.

All of which is true but until the larger community of founders and investors buy into the rational basis for their existence those common shares do not provide any incentive for a competent programmer to take the risk of working for a startup rather than for an established company.

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