Comment by toocool | Hacker News Reader

Comment by toocool | Hacker News Reader

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Good points. Two considerations:

First: Is it correct to assume that in normal conditions you should run away from any company with shady liquidation preferences?

I've been in a few "high quality" startups, and in most cases if the company was liquidated for a price larger or equal than the last valuation, essentially the preferred shares would convert to common, since the preferred status didn't give any advantage to them from that point on.

If the company sells for less than the last valuation then yes, common holders will be progressively wiped out since investors (preferred shareholders) need to recoup the money they invested, but at that point you really just placed a bet on the wrong startup, nobody has been "screwed".

Second: on strike price, from what I've personally seen one "advantage" of common options is that the strike price is usually a fraction of the actual preferred share price (let's say from 1/10th up to 1/3rd) so, even if the company valuation doesn't increase much, the employee can still gain some benefits (and this is assuming that my first consideration holds, since if there are aggressive liquidation preferences you're going to be screwed, and that there won't be too many dilutions down the road).

Mind to share your opinion? You seem very knowleadgeable

"First: Is it correct to assume that in normal conditions you should run away from any company with shady liquidation preferences?"

No you shouldn't run. Just factor it into the calculation. You might want to join the company for personal growth, or because the cash compensation makes it worthwhile. 'Shady' (by which I suppose you mean anything greater than 1X) liquidation preferences should affect your expectation of the future value of equity/options, but you can't value options or equity at less than zero.

"(preferred shareholders) need to recoup the money they invested, but at that point you really just placed a bet on the wrong startup, nobody has been "screwed"."

As long as everyone understands the terms (i.e. as long as employees understand the liquidation preferences), then I agree that 'nobody has been "screwed"'. But in many (most?) cases employees not only don't understand the liquidation preferences: they aren't even aware of their existence because they don't have access to the relevant documentation.

A minor quibble: if you consider options/equity as part of employee compensation, then I see nothing special about preferred shareholders than means they 'need to recoup the money they invested', any more than employees need to recoup the time they invested.

'one "advantage" of common options'

Advantage relative to what?

- Relative to cash? Cash can buy baby food. Common options can't.

- Relative to shares? Shares don't expire, and don't require the owner to risk additional money in order for some benefit that may or may not come.[0]

[0] Ignoring tax implications, which vary a lot between countries.

> A minor quibble: if you consider options/equity as part of employee compensation, then I see nothing special about preferred shareholders than means they 'need to recoup the money they invested', any more than employees need to recoup the time they invested.

That is a fair point. Although, can you compare this situation to other businesses where the treatments towards the workers are more fair? For example, I invest in real estate partnerships (syndications) where the sponsor does all the work (i.e. puts in time) and investors provide the capital to the sponsor to buy the deal and execute. in 100% of the cases, upon liquidation investors receive all their money back plus a preferred return (usually enough to make a 5-10% IRR). After that, if anything is left, the profits are split between sponsors and investors depending on the agreement. The sponsors also get a monthly fee (usually a % of the gross monthly revenues) to justify their time investment. In this case, the situation is quite similar to a startup, where employees get a monthly salary and have the option to participate in the upside, if they execute well. These kind of arrangements are quite customary in all industries where private equity is a way to bring capital.

> Advantage relative to what?

I interpreted your original statement as if you were implying that the strike price of the common options is typically equal to the current price of the preferred shares (quote: "the company may justify the strike price based on the valuation of the company at the last funding round"), and I was pointing out that's not the case, so the pricing has a slight advantage with respect to the price of the preferred shares, so if the company were to be sold today at the exact last round valuation (e.g. X), the employees would still net X - Y per every option they have (where Y is the strike price), as opposed to 0, even if those options were granted while the company had the same exact valuation. Maybe I just misinterpreted.

Of course it would definitely be better if startups granted shares rather than options, but I am not aware of any company at early-medium stages doing that.

> After that, if anything is left, the profits are split > between sponsors and investors depending on the agreement.

This is a complicated topic, probably with no perfect answer. But it's worth considering this: Is the equity granted to employees as a way to incentivise maximising shareholder value, or is it a substitute for regular (cash) compensation? I'd argue that, except for very senior or very early employees, it's the latter.

> the employees would still net X - Y per every option they have

Thanks! Your calculation is precisely the justification that I said companies may try to use to get you to accept an offer. And it often doesn't make sense.

To build on your example:

- 1,000,000 preferred shares at $X per share, with 2x liquidation preferences - 3,000,000 common shares (including employee option pool, and all employees get accelerated vesting on a liquidity event) - Employee options have a strike price of $Y, where Y=0.7X (a 30% discount to the last round).

If the company is sold tomorrow, at a valuation of $X per share, then that's $4X MM. The preferred shareholders get $2X MM (due to their 2x liquidation preference). The 3 MM common shares split the remaining $2X MM. So each common share gets $0.67X. This is less than the strike price. So the options are underwater.

I used a 2X liquidation preference to make the math easy. But there can be other provisision (e.g. an IRR ratchet) or situations (e.g. a flat- or down-round) which can cause a similar outcome.

Moreover, the naive X-Y valuation of each option doesn't account for (i) the riskiness of the eventual outcome, (ii) how far away that outcome is (time value of money), (iii) lack of liquidity (can't sell the options, for any price).

So you can't just take a discount of salary, and eplace the dollar amount with a number of options vesting this year, using that X-Y value per option.

Your logic makes sense. I have to point out though, that in reasonably "high quality" startups, what I've seen is:

- Absolutely 1X liquidation preference

- strike price between 0.1X and 0,3X the preferred

- No accelerated vesting :)

- Significant retention plans are given upon liquidation to the the productive engineering team members, regardless of how many options they owned (I personally know folks who made little fortunes even if their options were completely worthless on liquidation day)

That being said I agree with your salary discount thing. I worked in other startups and I had been victim of that, and I'd never take a significant haircut again for some Monopoly money, all it takes is some education.

Totally agree with everything you said.

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