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Comment by alecbenzer | Hacker News Reader

> don't deserve to be "preferred" instead of "common" because the VCs put in actual money

I agree with most of what you said, but a nit: one perspective I've heard on the motivation for preferred stock is this:

Suppose I give you $10M to start a company in exchange for 10% of it. You then easily sell the company for $9M, keeping 90% * $9M = $8.1M for yourself and returning $900k to me. Preferred (non-participating, 1x) shares prevent this problem by making sure you can't just run away with the money: you have to actually use it to build the business.

People investing in the company in non-liquid ways (e.g., the founders or engineers, via opportunity costs) aren't in the same boat, because their opportunity cost can't be immediately liquidated.

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Except employees do invest money in the business by exercising their options. And that money, dollar for dollar, buys them an inferior product: lower priority in the liquidation stack; less liquidity because of abusive bylaws restricting secondary transactions; less tax benefits since your “gains” are taxed upfront.

The lower the pay, and the higher the relative cost of exercising, the worse it gets. So higher-paid executives are less penalized than entry-level employees who might spend their savings exercising options that will end up worthless.

"And that money, dollar for dollar, buys them an inferior product: l"

No, employees are usually offered options at market value when they are issued. They are essentially 'free' at the time of their issue. If they 'cost something' at exercising time, then they are 'worth at least' the cost of exercising, and usually more.

An 'option' definitely has value beyond a stock, because you don't have to actually take any risk if you don't want to. You can just 'wait and see' - which has very material economic value.

> No, employees are usually offered options at market value when they are issued.

It absolutely is an inferior product. Preferred Stock comes with a preference, in the absolute best case it's 1:1; owners of Preferred Stock will get 100% of their money back in a sale of the company before Common Stock owners see $0.1. There are sometimes worse deals (for the employees) where Preferred Stock gets back 2:1 or worse.

Common Stock (what employees get as ISOs or NSOs) is absolutely an inferior product.

I believe the grandparents comment was about options not common stock.

You are not accounting for the optionality of the ISO.

The ISO is an option to buy a stock, not actual stock. An option on a stock has material value due to the de-risked nature of it.

Someone with 'preferred' shares gets their money back first, sure, but someone with an 'option' never even has to put their money in the first place. An 'option' gives you all of the upside with none of the downside.

Would you rather put $1M in a company for 10K 'preferred shares', or would you rather be given an option to buy 10K shares at 1 cent each. Without knowing anything else at all, you'd probably choose the later.

> Someone with 'preferred' shares gets their money back first, sure, but someone with an 'option' never even has to put their money in the first place.

That’s not true. They are paid for at very high opportunity costs.

Yes but the context here is liquid investment, which is what preferred stock are meant to be a defense for (at least according to what I've heard).

(The opportunity cost is also paid slowly over years; I think VCs get better terms in part for front-loading all the money.)

> An 'option' gives you all of the upside with none of the downside.

To see any of that upside you have to exercise the option. If the company has the common 90-day post-termination exercise window, that means if you want to change jobs you need to come up with cash to exercise what’s supposed to be part of your compensation, and if the FMV is much higher than the strike price, hand a bunch of cash to the IRS too.

Now you’ve put in your time as an employee and reinvested the salary the company gave you right back into the company, and you’re likely at the back of the line with common shares.

Yes, windows on exercising are also part of the value, but you are fundamentally misinterpreting the concept of investing real money and optionality.

Your misunderstanding leads you to believe that somehow an option is worth a lot less than a 1x participating stock, and it's not.

Again you side-stepped the comparable:

As an employee, even with a '90 day exercise window' which would, you chose for compensation (or what would most people chose?)

1) the ability to invest $1M for a bunch of preferred shares; or

2) a bunch of ISO's at a low exercise price?

Everyone will take the ISOs due to their riskless nature, now why would they take option 2 if it's so 'inferior'?

A 1x participating preferred is a perfectly rational type of financial instrument for VCs, and some type of ISO is actually well aligned for staff. Though things might evolve here and there, there is zero chance that the 1x preferred aspect is going away.

As an employee, instead of exercising, say $30k worth of ISO, I would much rather buy $30k of preferred at fair market value. Even better if I got a discount on fair market value. I would also like the company to pay the 30k upfront as a loan or sign-on bonus, a common practice for executives already.

> I would much rather buy $30k of preferred at fair market value.

Sure, but VCs aren't getting shares at FMV either.

My bad, I meant "at the same price as VCs". You are correct that's not what fair market value means.

> 1) the ability to invest $1M for a bunch of preferred shares; or > > 2) a bunch of ISO's at a low exercise price?

Why is this the choice? how about:

3) a bunch of ISOs of preferred shares at the current FMV

Why is a VC putting in $1m riskier than an employee taking a full time job with the company? Why can't an employee who vests shares get the same preference when they reinvest their own money into the company?

Also: why do startups cover the new hire’s early exercise cost upfront when the new hire is an executive, but not for other employees ?

Because 'Cash in hand' is worth more than the risky nature of what you are able to deliver with your 'time in', esp. after receiving a salary.

That you will never get 'preferred' ISO's is a fundamental fact of the market, which accounts for such risks.

Implying it's 'unfair' is more or less like saying 'your salary is only 1/2 what it should be'. There's definitely an underlying reason your salary is roughly where it is, it's better to understand why it is what it is.

Options can be issued on any kind of stock. I think it makes sense to issue them on preferred stock. However I don't know what is the common way of handling this. In fact, the companies I know don't even have separate classes of stock.

In these discussions it is important to understand that each company might have totally different arrangements when it comes to equity.

> It absolutely is an inferior product.

I don't think they were disputing that? But it's not dollar-for-dollar equivalent -- VCs are paying more (a lot more, I think usually) liquid cash per preferred share than employees are paying liquid cash per option of common stock.

This is one of the better explanations I've heard about preferred stock. I'd say the counter point for the engineers at least is that frequently the opportunity cost for them is vesting stock.

That lost revenue over the vesting period is IMHO the same as directly investing cash in the company that the company itself can liquidate. I would say that when shares are used for compensation with a vesting period they should be treated equivalently to investors that are directly putting cash in.

Also eng's typically get way way less grants than VCs putting up cash, so turning those shares to preferred shouldn't be a huge deal. But it is.

>Suppose I give you $10M to start a company in exchange for 10% of it.

The scenario you present is a great excuse for preferred stock but the same result could be achieved by other methods.

For example the minority shareholder in this case could be given a veto over the sale of the company for anything less than 1.x times the most recent valuation. Or they could be given the right of first refusal on the sale of any shares.

But yeah I think it's just generally pretty common in the gamut of human relationships for people to try and put themselves in positions where they can't get screwed by putting themselves in positions where they can do the screwing. It's also pretty common for predators and control-freaks to try to elevate themselves to advantageous positions by justifying it in terms of having the right to defend themselves.

I think a good partnership is one where all sides work together to not only align their interests, but also to structure things in a way where everyone feels safe. It's much easier for me to totally throw myself at a cause, especially one that may involve making sacrifices, if I don't have to worry about the potential for getting screwed for my efforts. Having shares that I know will be just as valuable as all the rest can go a long way towards achieving that.

Right, I think the way to think about this is that common shares are for sharing in the value created at the company over and above the money invested in building the company. If your company spends all that excess value on perks and generating usage, then your common is more likely to get wiped out.

So use tranches and don't invest in founders who are going to run away with your money? If you're afraid of losing $10M because you don't trust the founders to invest it in their business there are safer investments you can make.

But what if they just keep raising money at crazy valuations because it's easy to get and hoard?

Exactly. Or just skip the tranches and only give founders as much as they can reasonably spend proving that they deserve more money.

As an investor, you want the CEO working on the company, not spending all their time and focus raising incremental tiny rounds and being one raise away from complete failure at every step.

As an employee, you want the exact same, only much more critically and personally.

Huge rounds lead to share dilution. The best thing to want is organic growth that preempts the need to raise rounds.

That actually makes a lot of sense, thank you.

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