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Comment by Finbarr | Hacker News Reader

The bigger secret is that stock sold in secondary sales by founders and employees is usually common stock, and the purchasers will often get the right to convert this to preferred stock. This means that the company is instantly encumbered with a greater liquidation preference, without the increase in balance sheet to offset it.

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How is that legal and not considered self-dealing and unjust enrichment? If I was a minority common stock owner in a business I assume I would have standing to sue for damages if a majority owner or officer made my position materially worse while enriching themselves in such a manner? Are you sure such a right is typically granted? I mean even the gap between 409A valuations and preferred valuations, as well as a huge amount of precedent, give a different material value to preferred and common stock. Giving that right out of thin air in a sale by an insider is effectively theft from common holders and I have trouble believing what you’re saying as I’m not sure how that could be kosher, if perhaps infrequently litigated. But is it really standard like you make it sound? That would be a very dirty secret and I expect would and should lead to litigation.

Flip it around - it becomes a condition of the deal happening imposed by investors, who themselves are motivated to present the best deal to founders, and to have founders less economically stressed. No secondaries - no deal, and that doesn’t help anyone.

IANAL, but if you only have options, and not stock, do you still have standing to sue?

Who has the cause of action? The majority shareholders. Who authorized the stock sale? The majority shareholders. Are they really likely to sue the founder for something that the shareholders authorized?

Only in some states would minority shareholders have a cause of action. So there are some states in which the courts agree with you. As you might imagine, startups do not typically incorporate in those states.

It is very common and usually a condition of closing. Investors know that preferred is way better than common. They are buying highly speculative assets and want strong downside protection.

> How is that legal and not considered self-dealing and unjust enrichment?

because, ultimately, Capital writes the rules, and they chose to allow this

I used Founders Preferred shares to get liquidity at the A (for a now defunct startup).

In our case, we offered all vested employees the option of selling in the same round on the same terms.

I personally don’t recall any disclosure requirements at 10 people; however, we didn’t have that many participate so perhaps it didn’t apply.

In general, Founders Preferred does layer on the preference stack but also hopefully by a relatively trivial amount to the overall funding size.

Yes, as I mentioned it only applies when you have 10 sellers.

Founders never have preferred shares, at least not the same class of preferred (with the same preferences) as investors.

Not never. E.g. all the capital we as founders put in the business before we raised our seed round was converted into Series Seed Preferred shares at the same rights as angels / seed VC. Small portion of total equity but still.

Founder Preferred is a special class of stock that can convert into Preferred when sold. It’s different from Common as it doesn’t affect the 409A. IANAL.

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