Why do VCs get a 1x liquidation preference when investing?
I asked this question on Twitter and got a lot of responses that were actually civil and helpful, which is amazing (for Twitter).
We’ll get to those in a second.
Let’s back up first — what’s a liquidation preference?
In a VC deal, a liquidation preference determines who gets how much in the event that the company liquidates (like via a sale or bankruptcy).
VCs, the preferred shareholders, are prioritized in the event of a payout.
A 1x multiple guarantees the investor will get their full investment paid back before others (like founders and employees) are paid out.
My question: given that VCs make their money on the outliers and it is called “venture” capital, why do VCs get this protection? Is the idea that this aligns incentives in some way?
Here’s what the tweeps said:
No running away with the $$$: Say you raise $2M on $10M, investor gets 20% and you get 80%. If there’s no preferred, you could shut down the company the day the wire hits and return $0.4M and pocket $1.6M. — Sundeep Peechu, Felicis Ventures
It’s technical: Securities exemption and “cheap” options for employees. VCs can’t purchase non-preferred shares for more than 10% of their fund without destroying their exemption from registering. — Keith Rabois, Founders Fund
Spicy take: Investors taking advantage of the optimism and vanity of founders. — Dave Girouard, Upstart
When reality sets in: In my experience, liquidation stack is not understood or appreciated by early employees with option grants until after the fact. Truly a hard lesson for many that end up with $0 after an exit. — Eric Grafstrom, ExitGuide
Have your own thoughts? LMK.
Still got questions? Check out our VC explainer and the discussion on Twitter.