Who once was first shall be…first.

Startup-investor relationships need a David vs. Goliath moment

Liquidation preference is one of the most widely accepted and bizarre ideas in all of startup land. As a quick refresher, preferred stock with a liquidation preference is essentially a guarantee for investors. As opposed to common stock, it gives a bigger share of the pie to investors, and it means that founders and employees are sometimes left with very little in the event of a sale. That might seem strange, that the person who benefits most in the case of an exit is the investor who arrived a few months ago, instead of the people who have been working day and night for years, but that’s essentially what happens. In fact it’s so common that it’s rarely even discussed, but I’m here to tell you that it needs to change — and investors should be some of the first to realize it.

There are various reasons why investors need to take a different kind of preferred stock and founders need to stop giving out excessive preferred stock. And one of the biggest reasons has nothing to do with founders or investors. It has to do with employees, because in startups, the team is everything.

“As I look around, they don’t do it like my clique” Big Sean

The great employees that you need in a startup are rare. Many of them have been in startups before, and they’re becoming more and more sophisticated in their understanding of the industry. So when a large part of their compensation package is stock, they know that their common stock is truly valuable only so long as no one comes along grabbing for preferred shares.

As startups become the norm across our economy, all of the superficial perks that were once used to attract employees are losing their value. Having a foosball table, snacks, and a masseuse who comes to the office on Thursdays isn’t enough anymore. The only two things that make a difference are money and mission.

Only good compensation and a great mission make the best employees stay.

And even having a mission is losing its luster. Being a mission-driven startup is as common today as being a traditional corporation was forty years ago. Barriers to entry are so low that employees can even just leave and start their own company if they are looking for a different mission.

Like I said above, it’s all about the team, because execution is what makes a startup live. Ideas and capital are both commodities, and so it no longer makes sense for founders and investors to have the lion’s share with employees left fighting for scraps. The equity story for employees has to improve, and the startups that do this quickly are going to have a huge competitive advantage in the hiring landscape.

What does this mean for the various stakeholders in a company?

For founders, it means embracing transparency — part of your job is to talk to your employees about what goes on in board meetings, what goes on during fundraising negotiations. If equity is going to be a big part of your compensation packages, then you need to be honest about what those packages contain. You also need to defend your employees against those who would ask for too many rights. It’s your job to represent them with your board and to remember that without them there is no company. So keep your cap table clean — simple structure, as few special rights as possible, no funny clauses — and know that it’s better to have a lower valuation with a clean cap table than a higher valuation with no sense of equality and trust.

Too many founders lose touch with the intrinsic value of their company during the valuation game. The fear of missing the upside becomes a trap that ignores the real consequences of downsides for the team. And yes, a liquidation preference is a direct consequence of a “go big or go home” attitude. But that attitude shouldn’t necessarily be linked to the philosophy you have regarding fundraising terms. It’s fine to increase the level of risk within a company because that matches your ambitions as a founder and as a team. But it is a completely different story when you put everyone into a massive trap, when an 8/9-digit outcome isn’t a benefit for everyone because of a bad equity story. Aiming for the long term should guide you to build something clean at each step along the way.

For employees, it means pushing for a fair share that isn’t constantly eaten away at over time. You can’t ignore the risks taken by everyone else, but you shouldn’t act like you aren’t taking risks as well. Each day that you work for a startup is a day when you aren’t working on something else. Make sure that you’re upfront about why you’re there, both with the founders and with yourself.

And for investors, it’s simple: try to keep the cap table simple. I know it seems radical but maybe now is the moment to accept the fact that, if the power law is true, a liquidation preference is not the right tool for protecting against the downside. And even if the exit in any one case is not as big as anticipated or hoped for, having founders and employees getting a fair share of that smaller pie is what helps align founders, employees and investors over the long term. That’s healthy for the whole ecosystem. And yes, I’ve seen with my own eyes tier-one VCs, particularly in the US, giving up their liquidation preference for the benefit of the ecosystem.

But if even that doesn’t convince you, look on the immediate bright side — without liquidation preferences, most of the valuations in startup land would be about half of what they are right now. And that means outcomes where the winners will be even bigger ;)

Talking with Jean de La Rochebrochard from Kima Ventures, we played with a few scenarios for solving this dilemma:

  • Giving preferred shares to Employees
    GOOD: easy to implement
    BAD: it is a bad alignment strategy between Founders & Employees
  • Dividing a pool of shares between Founders & Employees with every round
    GOOD: maintains alignment between stakeholders
    BAD: a paperwork & tax nightmare; also creates very complicated outcome calculations for everyone
  • Common stock only
    GOOD: Radical ;)
    BAD: needs an equity story that respects this over time; very hard if the company needs multiple rounds but can work for non-capital intensive companies

At The Family we don’t have the solution yet — but we see the problem, and the pressures of an employee-driven industry are just the beginning. Investors need to think about this as soon as possible.