Why shouldn't investors and founders share the same equity as other employees? Investors can presumably adjust their valuation model accordingly.
Now the counter argument would be that whether its a 0x or a 1x it's a loss for the VC, as they're in the game of getting a 100x. And the founder's 'win' is only a win relative to the general population, they also lost as they could have made so much more if things went right.
So 1x liquidation is mostly to prevent a founder from trying to game the system. But I can totally see how it could feel unfair if there wasn't any ill behavior founder-side.
The issue of employee stock [options] vs founder stock is a somewhat separate issue.
It would seem like a 0x liquidation preference would provide protection in this scenario. i.e. VC is guaranteed to get his original investment back, but not a multiple of it.
"Say the VC puts in 5M, gets 20% equity. The founder sells for 5M"
VC could just get the 5M back in this case.
Liquidation preference in effect makes VC investment a hybrid between standard equity investment and a loan (it has an almost-guaranteed repayment feature, like a loan, but trades interest for potential upside.) Its better for the other stockholders (and for the success of the company) than VCs holding debt instruments, and its better for the VCs than common stock.
> On the surface, it seems wrong that employees get "worse" equity, i.e. common equity, than the investors and founders.
As long as the features of the type of equity they are receiving are taking into account when employees decide to accept an equity + salary compensation offer, I don't see the problem. Liquidation preference is a guarantee against losing money. The employees' guarantee against losing value for the time invested is the salary + benefits part of the salary + benefits + equity pay deal.
A 0x liquidation preference (insurance that you'll get your original investment back) would be more "bond-like" to me.
Good point that the employee can similarly adjust his/her price on the compensation offer. Unfortunately, I think a lot of employees in SV dont understand the dynamics at hand here.
If you are an early employee, it's also not possible to know if the company will accept a 2x liquidation pref investor in the future.
If investors put in $10M and the company sells for $9M, doesn't it all go to the investors?
If founders get the same preference as investors, it wouldn't be true. I just didn't think they normally did.
OTOH founders typically have much larger interests in the companies they own, leading to much higher control, which is for all intents and purposes a different class of stock, even though the rights of say, an employee, are nominally the same. Control is everything.
Also, P.S. most employees get options, not shares, which can be exercised into common shares, but are a little different with regard to tax and the fact that they must be "purchased" or exercised.
Which makes me wonder, if a company raises $1mil (1 million shares, $1/share) @ $9mil pre-money, that means the investors get 10% or, say, 1mil/10mil shares. But is it really fair to extrapolate that 10% ownership for $1mil means the whole thing is worth $10mil, given the significantly different provisions (ratcheted anti-dilution, pro rata/drag along rights, information rights, liquidation preference) their shares tend to have over common?
Maybe the SV convention of treating all shares as equal when talking about valuations should be examined more closely.
On common stock though, I don't think that'll fly. There are a number of ways where founders with board control can screw a minority shareholder. For eg. they can issue 10x the current outstanding shares to their family, or appoint their friends to the board, or sell the company, or sell the company. It's only in extreme cases that VC's will expose themselves like that. I believe facebook's first institutional round was for common stock and no board seat.
I'm speaking in generalities since I'm not sure about specifics, but as an example an investor might be willing to accept a smaller (i.e. less controlling) stake with liquidation preferences for the same price, which leaves you more equity to sell to others.
Or, if new investors give a new investor a liquidation preference, they could ride along with an outside chance of seeing some upside. In that light, an investor with a liquidation preference is preferable to an asset sale.
