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Comment by eoghan | Hacker News Reader

I don't generally disagree that first-time founders should think carefully before raising venture capital, but the example used to back up this statement is misguided on two counts.

1. It implies that your VC partner(s) can decide to sell your company without your wish. For the size of business mentioned here, this is unlikely. E.g. Even after we raise our next round (Series B), an acquisition can't happen without the founders' concent.

2. 2x liquidation preferences are not standard these days. I don't know anyone who's raised on more than 1x.

I think the author has a relatively refreshingly fair view on raising capital vs. bootstrapping, but the misunderstandings I've highlighted are typical. For any aspiring entrepreneur, I can't more strongly recommend you do your homework before deciding that raising venture capital is not for you.

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IMHO, even the 1x liquidation preference is a clause that screws up the entrepreneur and the company. If I raise $5m in year 1 and end up creating a company after 6 years worth $5m in equity value, the VC should take the -50% hit, but they should not be allowed to screwup the entire cap table, exit/liquidity options simply because the VC went in at a high price.

This 1x-2x liquidation preference clause is unheard of in any other asset class, be it debt, mezzanine, etc.; and it's not even used by investment funds, private equity, and other professional investors.

Then don't take money with preferences attached. Good luck, though, because preferences correct an incentive imbalance that is extremely concerning to venture capitalists (that you'll happily accept an outcome that will lose money for the investor).

What do you mean with "preferences correct an incentive imbalance that is extremely concerning to venture capitalists"? and why don't other investors in other asset classes experience this "incentive imbalance"?

Because investors in other asset classes aren't investing in individual entrepreneurs with barely-established businesses whose lives could be substantially improved with low single digit millions of dollars, where the returns implied by such a reward would also imply a total failure for the investors themselves.

It's a principal/agent problem. In taking investor money, operators assume some responsibility for generating returns for them. Nobody would invest without the promise of those potential returns. But operators incentives are, absent preferences, actually not aligned with their investors: they would be better off not trying to generate the returns they promised to try to generate, but rather to hew to a conservative strategy that is almost certain not to generate returns but will ensure a golden parachute for the operators.

Preferences correct for this problem, sometimes elegantly: they say "you can take this money to try to generate the returns you promised, but it would be irrational for you to use it to build the small exit you promised us you wouldn't be aiming for."

"principal/agent" dynamics are no different for other asset classes, and a liquidation preferences is by no means the best way to align interests. liquidation preference clauses assume investors have invested at a price where they see considerable upside in a business/market. Unfortunately, investors, like all other humans make bad judgement calls, it can certainly be the case where an (price-wise) aggressive investor prices out an entrepreneur/company, whatever the funding round, be it seed or Z round. Having said that, it's the entrepreneurs call to learn and know when to avoid these risks. In the startup world, caveat emptor applies to both entrepreneur and investor.

This comment isn't responsive. What is the other asset class in which investors sink large amounts of money into 2-4 individual people with no established business and nothing to lose? That's where the principal/agent problem comes from. PE funds do not have the same problem.

"2-4 individual people with no established business and nothing to lose" is quite a broad-brush to define how startups and entrepreneurs are. I don't think that $200k qualifies as "sink large amounts of money". My point regarding liquidation preference is that this clause is prevalent across all funding stages, even when the company has an established management team, considerable cash flow, etc. "PE funds do not have the same problem." I have disagree with that statement, private equity funds do have big principal-agent problems (family owned businesses, first time CEOs, strategy, capital structure, etc), and every time we come across these they are solved with veto rights over capex, acquisitions and capital structure, but definitely not pricing other shareholders/management out of the cap table.

This is silly. A $200k deal doesn't come with preferences and if it did it wouldn't matter anyways, because $200k is a small fraction of even a marginal exit.

If you take a number which is for argument sake and call it "silly", that is fine by me. To argue that liquidity preference clauses are the ONLY method to avoid the principal-agent problem (and that's not the only reason it's there in the first place), both you and I know that there are other, more entrepreneur friendly, methods to go around this issue.

The other way to correct for this problem is founder cash-outs, which require some negotiating leverage but solve it even more elegantly. Rather than saying "We're worried that you'll take a small exit that would be great for you but a disaster for us", they say "we'll pay out that small exit we're worried you'll take, because you're being offered it anyway, and now you have the same incentives we do to shoot for the fences because you're already independently wealthy." It aligns incentives almost totally, and is viewed as a benefit rather than a restriction by everyone involved.

If you got $5M investment and then sold the whole business for $5M then what exactly did you (as a founder) contribute?

And if you did not contribute anything, then why do you expect to get paid?

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