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Liquidation preferences for investors putting actual cash into a business exist for a reason. Suppose I have a company idea, maybe an early prototype and manage to raise $2MM at $10MM post-money valuation. The investors have a 20% stake for their investment.

If I decide the next day, “Nah, it’s not going to work; let’s close the company and distribute the assets to the shareholders,” it would be manifestly unfair for the 80% shareholders to take $1.6MM of the $2MM in the bank and give the VCs back the $400K that represents their 20% stake in the bank account.

Liquidation preferences ensure that the first $2MM that comes out goes to them.

Imagine you have an engineer who could be working at BigTechCo; she works at your company a year, and then that raise you specify happens. Engineer continues to work there for three more years. Company amounts to little, acquired for $2MM, engineer gets nothing.

Of course, everyone is disappointed. But it's still unfair for that engineer who gave up half a million dollars or more to work at the startup to get nothing. You might say that the engineer should be aware that they agreed to a way of structuring equity that means it's likely they'll get screwed. Fair enough! But all of this discussion is meant to make readers aware that, yes, the industry standard practice is to screw over the people who have the most skin in the game.

Why is it unfair? The engineer was part of a team that collectively destroyed economic value. What is the fair portion of bonus on top of salary that they should be rewarded with for that performance?

By all means understand it; I’ll never argue against that, but I find liquidation preferences quite reasonable.

The VCs are also part of the team that collectively destroyed economic value. They can't simultaneously claim credit for every success and disavow every failure.

This is a fair point and I’d never looked at it that way before. Thanks!

We have a lemon socialism banking system. Obama made certain that 100% of bankers wiped out in 2007 paid NO PRICE for their recklessness; he prosecuted NO ONE.

It's not a reward. The engineer's work is a commodity they are selling to the company. Partly for wages and partly in exchange for equity. That is a real investment they are losing just like the VC's if things go bust.

Really that sums up the american dream, completely. Get rich by screwing the people whose hard labor built your enterprise, often based on "borrowed" software (Example: Microsoft 'borrowed' a source listing of a basic interpreter written at DEC.) It happens every day in the USA, and it's why conservatives love it so much.

How often does something like this happen?

I don't have statistics, but I believe the more common scenario is that the company gets acquired, and the return on investment is not the 10x or 1000x or 1000000x the VCs hoped for, so they recoup their original investment. Leaving the engineers with options worth nothing.

I view liquidation preferences as VCs offloading risk to employees because they can.

IMO, it doesn’t happen in part because the liquidation preferences are present. If they weren’t there, a great many startup founders would find their highest expected value play to be to close up, distribute the funds, and go back to working for someone else. Maybe not the day after funding, but 3, 6, or 18 months in. “This isn’t working out, but I can cash out from the cash left in the bank.”

Just like the “declare strategic bankruptcy a few months before graduation” doesn’t happen much because student loans aren’t discharged in bankruptcy.

Both moves would “break the game” in a very similar way and so are blocked.

You have a point. However, it would be very easy to distinguish between this scenario, and a sale of the company. VCs don't make this distinction. They could.

> a great many startup founders would find their highest expected value play to be to close up, distribute the funds, and go back to working for someone else

This is absolutely correct and it SPEAKS VOLUMES about the reality of the startup world, even apart from this discussion on liquidation preferences. I'd recommend anyone looking at working for a startup to consider the above and then consider the fact that as an employee they'd be in an even worse position than those founders before turning down that far more lucrative offer from BigTechCo.

> Suppose I have a company idea, maybe an early prototype and manage to raise $2MM at $10MM post-money valuation. The investors have a 20% stake for their investment.

The rich technically have less personal risk -- that's because, well, they're rich. GP arguably took more personal risk, took less pay, and created the machinery that made the company profitable.

If you want to say that the original $2M is paid out before anyone else is, that's fine, especially in a sinking ship.

If you mean to say that on a %1000 increase of company valuation, GP should not get his share because, well, he didn't fund $2M dollars -- that's _utter_ bullshit. And arguing that VC's should get preferential treatment so they can directly screw over the people who directly provided the growth is the stupidest argument I've heard for this clause.

Do you read any of the latter in my argument above as to why liquidation preferences exist?

It seems to me that you built and eviscerated a strawman right in front of us.

I think the point the OP is trying to make is that the structure that you described, while great in protecting investors, seems pretty unfair when the startups do succeed. So while recouping the intitial investment preferentially sounds great, it shouldn’t be extended as far as giving the 20% investors the lions share of a successful exit before the people that actually built value.

The liquidity preferences could certainly be structured in a fairer fashion. Just because it’s currently structured this way doesn’t mean that it needs to be always or that it’s a great model ( it’s not unless you’re a VC, which is basically the point).

Imagine if you had a very deal-term savvy crew of engineer hires. They then proceed claim that "the compensation cut we have taken by working here directly offsets cash you would otherwise have to spend/raise. This should count as a capital investment and should therefore entitle us to 1x preference just like for the other investors have."

Would you think this is a legitimate claim?

Did you see where I said, "If you mean to say..." You could just have said, "No. I agree with you on that point."

> The rich technically have less personal risk

It's silly to automatically assume that "investor" or "capitalist" is someone rich. Chances are, the VC get their money from banks and pension funds who, in the end, invest money of people who earn much less than an average startup employee.

The point is that they’re (or at least should be) diversifying their investments, in contrast to most employees, who only have a single job.

No, it is not manifest. Investors should ideally not invest in companies that are not "Going Concerns"[1][2]. If the company fails, all investors (including employees who invest with their time and energy) should bear the losses. The increased risk is what usually justifies the outsized returns.

[1] https://en.wikipedia.org/wiki/Going_concern

[2] https://ssfllp.com/going-concern-rules-company/

You don't have to screw the engineers to safeguard your investment from fraud.

Come up with a different mechanism if you ever want anyone competent to work at your startup.

My talent, time and energy is as good as your cash.

As an employee (who’s also investing actual money, i.e. the higher salary I’m not making elsewhere, as well as labour & time) I also want “liquidation preferences” - 500k per year of working, vested monthly, senior to investor’s preferences - and it’s only fair, as I’m both investing and risking much more!

None of this logic applies to equity granted to employees, which are already subject to vesting. The argument you're making is actually for founder vesting, which is a separate issue.

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