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Comment by cj | Hacker News Reader

Liquidation Preference.

In very simple terms:

"Liquidation Preference" is an agreement between a company and an investor that when the company is acquired or IPOs, the company will pay the investor some specific amount of money BEFORE any other shareholders get paid. If the company negotiated the funding well, the liquidation preference might be 1x (basically saying the company promises to pay back, in full, the investor's original investment if the company is ever sold)

Things get scary when the liquidation preference creeps up to 2x, 3x, or higher. It's possible to raise $5mm with a 3x liquidation preference... which means that the investor will get $15mm payout BEFORE any other shareholders in the event of an exit (which means that, after raising that $5mm, the company can not have an exit less than $15mm without 100% all the proceeds going to the original investors).

Raising $5mm with a 3x liquidation preference, then selling your company for $15mm, is an easy example of how (even founders) can walk away with $0 after a $15mm sale.

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It always baffles me when the top comment isn't discussing the article, but provides a response to the headline as if the article doesn't even exist.

What's baffling about it? If someone were to only read the title and not the article and came to the comments section, a summary about the title would be desired. What you're probably baffled about is why do people only read the title and not the article.

I’m not sure... HN is supposed to be real time discussions of articles. summarizing the article not only is not discussion (read it is regurgitation / bastardization) but any argument / discussion had based on the summary will be inaccurate as they are going off of the words of another, who more than likely integrated logical fallacies that did not exist before the comment.

FWIW this happens on reddit too as so many posts have clickbait titles, people are trained to go directly to the comments to find out the non clickbait version.

I mean, I guess that's an issue sometimes, but this comment quite nicely summarized what the article explained at length.

I think this brief summary was nice. The title to linked article was clickbaity.

The headline is grabby and precisely describes the situation she's explaining.

It saves a click for many people who are tired of clickbait.

In their defense, it is on Medium...

Good point. I am not going to read this article anymore.

:c but please!

Yeah, sometimes the comments are more cogent, clear and concise than someone paid by the word.

I often check the comments first to see if there is one as clear and concise as CJ's. Then I don't need to skim a lengthy article for the information I'm interested in - such as the answer to the question in the headline in this case.

Better that than “random personal anecdote only loosely related to the title.” Those are too common.

You mean the linked article isn't just a 750-word essay version of "Huh?!?!"

Some people rather quickly see the reason than read about the leaves blowing on one crispy fall evening as a dog howled in the distance and the city lights twinkled beneath the moon.

The clickbait title was what got me to this page, so why not? :)

If it saves me a click on medium, it's perfect.

It is clearly not an article, it is question someone posed. Here is the answer.

Even more insidious: Participating Preferred, which is effectively double-dipping.

That's the one where they get liquidity prefs up front and then also get to participate with common, right? Worked for a company that had that.

Fortunately we had a violent restructure and an insane cap table got crunched down, cleaned up and all that stuff was made null and void. Definitely a "useful crisis" as we got to an exit later without any liquidity prefs hanging over our head.

For those not so deep in the world of startup, can you give a layman's explanation of what Participating Preferred is?

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.

As I understand it, from memory:

I invest $100 for 20% of your venture. You sell for $200.

Standard preference: I get $100, not $40, as my % would suggest, because I get at least every dollar I invested back.

2x preference: I get all $200, because I'm promised at least 2x my investment back.

Participating preferred: I get $120 (I think?) --- I first get my invested dollars back, and then I still get my % of the venture.

To expand on your example:

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.

Check out Venture Deals by Feld & Mendelson. It explains in layman's terms most anything you'll encounter during fundraising.

https://en.wikipedia.org/wiki/Participating_preferred_stock

So in your example, the investors are basically getting a 300% return if the company sells for 15M or more?

In my opinion:

Liquidation preference of 1x (or lower) is just sensible alignment of investor and founder incentives. The investor wants to make sure that if they buy 20% of the company for $5M, the founders aren't now incented to take advantage of them (in an extreme example: the day after the fundraising, liquidating the company for its assets, taking home $4M themselves and handing the investor back $1M. In a less extreme example, selling the company (in toto) for $10M a year or two later).

Liquidation preference of higher than 1x is a whole different thing. It's, at its most benign, something kind of like a financial instrument a little more like debt than stock, trading a more-guaranteed return for a lower price, or at its most pernicious, basically an attempt to create false impressions of a company's value. If you sell stock with a x3 liquidation preference, that is deeply different, and conveys considerably less investor confidence, than selling the same stock at the same price with x1 liquidation preference, but the press releases get to not mention the preference.

It may be sensible for the founders and investors, but is it sensible for the employees? Many startup employees are paid to a significant extent in stock and do not understand the situation they end up in. They are also powerless and just have to trust that the founders and investors will treat them well.

Rationally, this leads to many of the best people ignoring the startup world

VCs really don't care about "sweat equity" or "discounted salary equity". They believe that if you don't bring actual cash to the table then you aren't risking as much as them (even though they are only putting their clients money, not their personal money in most cases).

That's one reason I didn't have trouble bailing on a startup I helped start. We took in $1.5mm, did some things poorly (such is life but learned good lessons from them) and even with a path forward we would have still required some more investment (since we weren't profitable). Therefore I knew what the current liquidation preference was, I computed what another round's liquidation preference would add, and it became clear we'd have to sell at $30-50m just for me to start getting money.

The likelihood of that happening was small, and the feeling of being un-incentivized from selling at a respectable $20m made me realize the whole game was stupid and rigged. Now I work at a bank making almost 3x of what I made in hard cash (plus better benefits which equals hardware) and that extra money is giving me much better returns in my retirement and stock accounts, and a better quality of life (and less stress).

I was the third employee at a startup. I was young and stupid and thought "20,000 shares" was a lot. I worked my ass off, it was immensely stressful, but we built and launched a product. I later found out it wasn't much of a stake at all- .1% and that's even before any dilution shenanigans and all that. We took a paycut part of the way through, had our 401k contributions slashed and such.

A company in the space (but doing something different) called and made me an offer for twice what I was making. I was the lead developer by that point, had my hands in every significant piece of code, understood how everything fit together and such, and was appalled when I found out that I had such a small piece of the total pie. I demanded more, like 20x more, and they made it sound like I was asking to sleep with their wives. Then they absolutely howled that I was screwing them over by leaving right at launch- they asked me to stay for 3 months, which I said sure- if you match my new salary plus a little more as a retention bonus and to make up for some of the paycut, and again they howled at how could I do this to them...

It was a painful lesson, but I learned something very important- Do not work like you are an owner if you are just an employee! I still to this day (this was 10 years ago now) feel very taken advantage of. I was working tons of late nights and weekends, was a super fanboy of the company, at one point I was going to buy us a company logo made out of Legos to hang on our wall, and now I just cringe at the thought.

There are so many ways to lose in the startup game, just so many, its really not worth playing anymore IMHO unless you are a founder or very early stage employee with material access to the financials and such.

+1 I initially learned this lesson on the other side of, when was part of a startup during college. I was putting in long hours alongside my co-founder, but my staff were doing merely an adequate job.

For a while I was confused and unsure why they weren't also pulling long hours, but I eventually learned the lesson. I was working hard to protect my baby, while my staff were just seeking to gain some experience in a cool niche. I would either have to realign incentives for them to also feel compelled to pull long hours, or I'd have to recalibrate my expectations.

In retrospect, I'm not sure what took me so long to realize this, but I'm glad it happened relatively early on in my life. The first job I took out of college, I made sure to keep my effort in line with my compensation and investment in the company.

I was the third "employee" at an internet startup (maybe the fourth, I forget) after the CEO and the lead tech guy, and I got...$5/hr as a 1099 consultant. That's actually more like $8 in today's money. I just looked it up and it was the same year eBay (AuctionWeb) was founded. Coincidentally my boss asked me to (with hindsight) basically create eBay and I didn't have a clue where to start or the necessary hubris. After that, they figured I wasn't useful as a programmer (I was hired to answer the phones).

>, but is it sensible for the employees?

Yes, if the employees' future paychecks for the next few months is being funded by that VC check. If the options are (a) VC money - but can only get it with liquidation preference ... or (b) insist on no liquidation preference - and therefore no VC agrees which leads to bankruptcy ... the "sensible for employees" is a moot point because the constraints of limited runway mean the employees care more about steady paychecks rather than owning worthless stock of a bankrupt company. (E.g. Google's first employees' salaries were funded by $25 million VC money from Sequioa and KPCB because Google had near zero revenue. Yes, Sequioa & KPCB had liquidation preference but it was irrelevant to employees since they needed the paychecks.)

On the other hand, if payroll expenses can be funded by revenue and the VC check is optional, maybe not.

That's equity compensation, in my view. It's not like it's different at the FAANGs. If you go to work at Apple, and you work super hard, and the company declines in stock value from $5jillion to $3jillion, nobody is like, "Whaaaat? Why didn't my equity go up in price? I worked really hard, and also $3jillion is still a ton of money!"

Equity compensation is about owning part of the COMPANY. If the company has destroyed value -- if it is now worth less than its bank account, with no company attached, was worth before any revenue -- then your equity is valueless.

Asking for the reward of equity with no risk is weird.

Definitely agree that equity compensation carries risk.

However, I've seen equity pitched as a way to "make up" for the lower cash comp a startup might offer.

This is probably the wrong way to look at equity. The expected value of the equity might make up for lower cash comp, but that's with a large sample size. Employees don't get that benefit at all.

It's definitely up to the employee to understand the risks, but frequently they don't, and employers don't actively educate their employees.

I have no knowledge of the startup world, but based on the article, if both the founder and employees have common shares then their incentives are aligned (i.e. the founder wouldn't want to sell the company unless the price was well above the preference overhang). Of course, deception can pay a role in making this less fair.

The article mentions at least one reason why the incentives often aren't aligned: a carve-out agreement that guarantees specific people (often founders) a cut from the "preferred" part of the pie. As I understood it, this cut is completely unrelated to the amount of shares (common or otherwise) those people own and is a separate agreement saying that they get eg. 10% of the money in the event of a sale.

Often, founders get paid money directly as part of the acquisition to make them greenlight it.

How often is often? Can you name 3 such cases?

Often enough that it is mentioned in the article.

Carve-outs in general are mentioned in the article. A common type of carve-out: the employee retention pool. The article does not say that founder carve-outs are common. I'm sure they've happened, but you said they happen "often", as a way to get founders to greenlight deals. Do you know how often that happens?

I don't know how often that happens, so I can't add anything to that part of the discussion.

I can only reason that it depends on whether the founder still has voting control of the company, but that's implied with "greenlighting".

WeWork is a similar situation where the founder is effectively getting a carve-out to greenlight the deal. That's only one example, though.

Use a lock-up (like public markets) or have the preferences expire / reduce (like the contracts some banks gave pre-IPO Uber employees). Or be like Softbank and demand a 7% dividend on invested capital. Or if you don’t actually have a constructive relationship with the founders, don’t invest.

The only warrant for preferences is for fueling carry and information arbitrage within the VC circle. There is zero benefit to employees, who thankfully know more today.

Yep. They're locking in their upside to offset for the risk they see in putting in $5 million. 3x preferred is either a weak founder with a good company or more likely an ok founder desperate for funding and therefore pretty high risk for the investor.

Yes.

Say a company sells 10% of itself to an investor for $10M, with a 2x preference.

If the company sells for $100M, the investor gets $20M off the top. My question: Does the investor still own 10% of the shares, and will they recoup $8M of the remaining $80M?

Is their $10M investment now worth $20M or $28M?

That's where the difference between participating and non-participating preferences come in. Participating meaning that they also participate in the remaining surplus (so on your example $28M). Non-participating means they choose whichever is better (in your example they wouldn't since $20M is better than 10% of $100M, but if the company sold for $300M they'd choose $30M instead of the $20M).

Shitz, and here I go thinking I knew everything about these sorts of things by attending a 5-day lunch-time course at Capital Factory on Founders Academy Essentials… So much for those cap tables!

That's called participation and it's negotiated as part of the raise.

Non-participating: at liquidation, an investor chooses. They may either be paid back their investment (or more, if they have a multiple), OR they may choose to convert to common and get that percentage. They will, obviously, choose whichever pays them more =P

Participating is then also obvious: investors get their money (or negotiated multiple) out, and then get their ownership percentage of the remainder.

One thing that happens is companies very eager to raise monster rounds agree to shitty terms on all of the above. It's a lever founders and investors can manipulate to raise bigger rounds.

see eg https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidat...

So your answer: $28m. Because if you agreed to 2x preferences, you're raising on shit terms and the investor probably got participation as well.

Generally if you raise on good terms, you can get a 1x non-participating.

But it's good to know the details.

$20M

My tl;dr:

There is preferred stock (full price; i.e. investors) and common stock (incentive plans; i.e. founders/employees).

A liquidation employs one of two methods to distribute payment, depending on which is better for preferred shareholders:

* Method 1. Preferred stock is converted into common stock (usually 1:1). All common stock receives payment.

* Method 2. Preferred stock first receives payment according to liquidation preference which a multiple of the initial purchase value. Then participating preferred stock is converted into common stock (usually 1:1). Finally, all common stock receives the remainder of payment, if any. During preference, carveouts may protect certainly common shareholders.

In good exits, method 1 is used. In bad or mediocre exits method 2 is used.

---

Liquidation preference and participation are not required, but are tools to give founders more money per investor share.

Nowadays, you should be able to get a solid valuation for 1x liquidation preference, non-participating, no carveouts.

IMO this is a sensible compromise; if you can't even keep the initial investment value, you really haven't done well anyway.

There are often dividends attached to preferred shares. This is basically interest, and may or may not accrue, and has to be paid out eventually. That's even more money off the top.

Yeah I hear the terms 'liquidation preference' much more often than 'preference overhang'.

Founders are protected through carveouts that they can negotiate as part of the acquisition.

I think I am misunderstanding. Is liquidation rate basically interest?

Interest rate is something that gets regularly paid out on an investment.

Liquidation preference is something that typically pays out once when an illiquid investment (private company stock) becomes liquid (IPO or sells).

They both share aspects in that you are investing money up front but they have different rules to how you get a return on that investment.

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