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