Here’s a horror story every startup employee should be aware of.

Earlier this week, we published a story about the three ways VCs and CEOs screw-over startup employees.

One of those three ways is through the difference between “preferred stock,” which investors get, and “common stock,” which employees get.

Among other special rights, the owners of preferred stock get “liquidation preferences.”

What that means is that when the startup sells, or liquidates, the owners of preferred stock gets a guaranteed amount of money from the sale.

Often, the owner of preferred stock gets a guaranteed return of 1X their investment.

Imagine a VC that buys 50% of a company for $US50 million, for a $US100 million post-money valuation. If that company then sells for $US75 million, the VC gets more than 50% of the $US75 million. The VC gets his or her $US50 million out first, and then half of the remaining $US25 million ($12.5 million) for a total return of $US62.5 million. The common stock holders split the remaining $US12.5 million.

That’s a 1X liquidation preference. In recent years, it’s become the most common liquidation preference for VC firms investing in startups.

A 1X liquidation preference isn’t unfair. The people who bring the capital should have some protection. But it’s something employees should know about. Otherwise, it could lead to a big shock.

Where startup employees can get really screwed is when preferred stock owners have 2x or 3x liquidation preferences.

Here’s how that works.

Imagine a VC that buys the 50% of a company for $US50 million, at the same $US100 million post-money valuation. Imagine that VC has a 2X liquidation preference.

If that company then sells for $US75 million, the VC gets more than 50% of the $US75 million.

The VC gets the whole $US75 million.

Common stock holders get zilch.

In fact, common stock holders would get zero money unless the company sold for more than twice the amount the investors put in — in this case, $US100 million.

Even if the company sold for $US150 million, common stock holders would only split the remaining $US50 million.

In some cases, the preferences are structured so that the investors would then even get 50% of the remaining $US50 million.

Thinking about 2x liquidation preferences, you can imagine a scenario in which some ignorant senior executive thought he owned 2% of a company and thought he was going to make $US1.5 million from a $US75 million sale, but actually made nothing.

In the comments of our post, one reader of our story about the three ways VCs and CEOs screw-over startup employees told just such a hypothetical horror story:

VC puts in ten million dollars and gets 50% of the stock (thus valuing the company at $US20 million dollars). For simplicity, let’s say that the employees get the other 50% of the stock.

The VC stock is preferred stock. The employees’ stock is common stock. This is where the term “liquidation preference” comes in. A common formula would be that the VC has a 2x liquidation preference. This means that the VC gets to take double their original investment out of the company before any other shareholders get their first dollar.

So, if our example company is worth $US20 million at the time of the VC investment, and then triples in value, the company is worth $US60 million. So, you would think that the employees would get half of that, i.e. $US30 million. However, the VC has a 2x liquidation preference, so the first $US20 million goes to the VC (i.e. 2x their original investment.) Only after that $US20 million is paid out, do the remaining proceeds get split 50/50. Therefore the VC will get every dollar up to $US20 million and will split the remaining $US40 million with the employees. In this example the VC would get $US40 million and the employees get $US20 million. So the VC quadrupled their investment despite the company’s value only tripling. Meanwhile, the employees only saw a doubling of the value of their shares, despite the company’s value tripling.

It is worse if the company does not do so well. If the company only rises in value from $US20 million to $US30 million, the VCs will get all of the first $US20 million, plus half of the next $US10 million. So the VC gets $US25 million and the employees’ portion is worth $US5 million, which means the value of their shares went down, so they will have lost money if they had exercised their options and bought shares in the beginning. If they were only holding options, they would be underwater and worthless.

What it all boils down to is that startup employees should make sure they know exactly what kind of liquidation preferences their company’s preferred stockholders own. That way they actually know how much their equity would be worth in various outcomes.

If you’re a early stage startup employee, and you’re working for a CEO who refuses to share such details, be suspicious. Or maybe even go find a new job, because you’re working for a jerk.

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