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It seems completely absurd to me that preferred shares exist, and one of the reasons I always hesitate whenever I'm offered equity. For anyone curious, here's

It seems completely absurd to me that preferred shares exist, and one of the reasons I always hesitate whenever I'm offered equity. For anyone curious, here's a good explaination: https://www.capshare.com/blog/how-preferred-stock-affects-the-value-of-your-equity/ https://www.capshare.com/blog/how-preferred-stock-affects-th... They basically shift a lot of downside risk from the preferred share owners (usually a VC firm I guess) to the founders and employees in the startup, which in theory makes them more likely to invest in more startups. But in the long term, this seems like it consolidates captial (which is generally a bad thing IMO). It seems as though it just makes investing in any startup that's expected to at least be acquired at some point a 'risk-free' investment. Anyone have any thoughts on why this might be a good thing?

deleted 9y ago
[deleted]
conanbatt 9y ago
I made another comment about them below, but i will repeat in a different way. People have their own assessment of what is valuable, and getting exactly what they want means they are willing to part with as much utility. A person that loves sandwiches with blue cheese is willing to pay more for that cheese than he would with the a regular sandwich. The existence of blue cheese sandwiches is moderately irrelevant to the existence of regular sandwiches. And banning them would only increase the price of regular sandwiches and also make those people less happy. Less sandwiches would be sold. Preferred shares don't really hit common shares. If you knew exactly how it went, then you would make an assessment of the value of the shares as they are. Your internal valuation of sandwiches will adjust to the existence of blue cheese sandwiches. The reason why they feel unfair, and they are unfair in this sense, is that the guys with preferred shares know what they are getting, and you dont. And also, as an employee you dont get to buy preferred shares. If you dont know the price of blue cheese sandwiches and you can't buy them, you will find them unfair. Banning sandwiches is not the solution to the problem.
- GeneralTspoon 9y ago
  I'm not so sure about the analogy, but I get your point. I think you're right that transparency is a big problem here. As long as others have perfect knowledge of the situation, they can factor the extra risk into their negotiations (e.g. Ask for more equity, because common shares are worth less if there are others with preferred shares). The terminology surrounding this is quite misleading too - as you mentioned in the grandparent, having 1% of a company sold for 1M, doesn't mean you'll get 10k, which is pretty weird. Not sure what the solution is though - maybe it's just for everyone to be aware of how preferred stock works and make the cap table public. It would also be nice if there were a standardised way for a company to say "We won't offer preferred stock for at least X years". Something like that would make me much more confident in taking equity in a company. Which, in principle, is actually what I want to do - but all these kinds of tricks essentially mean I can't (because I can't properly estimate the value of what I'm offered). Public cap tables would help, but wouldn't protect against future investment rounds with preferred shares.
  - conanbatt 9y ago
    If it were of public knowledge that when a company IPO's, employees in total collect less than 10% of the gains, the public outrage would soon ban the practices that we see everyday. Today we have a lottery where we dont know the winners and so they are protected. I dont have animosity against investors for protecting their gains, that is fine (for them, ofc, but they are reacting to their incentives). The main reason cap tables are hidden is because the only person that can buy shares is an accredited investor, which means the company has to cater to them, not to capital. If you as an employee were able to buy and sell the shares with liberty, companies would almost immediately make cap tables public to get cheaper funding from the general public. Suddenly, investors capacity to ask for things like privacy and preferred shares would dissipate: there are millions of employees in the bay area alone that would pour considerable money into it. Increased capital means less concentrated gains, larger absolute gains, considerable increase in wages and overall greater investing efficiency.
    - kelnos 9y ago
eldavido 9y ago
It isn't absurd. You need to distinguish between participating and non-participating preferred. Participating preferred is a lot worse than non-participating, which is always converted into equity in the success case. The scenario this is trying to block is that entrepreneur raises $1mil for 10% of the company, and it's flipped tomorrow for $5mil. The investor gets 500k=50% loss in one day. It's completely reasonable and fair IMO that an investor should want protection in this case. What's not reasonable is the way silly SV journalists treat preferred as equivalently-valued as common. It's not, it's worth a lot more, making it incorrect to say that "10% of company is 1 mil => whole company worth 10 mil" when that 10% is preferred. It's probably more like 5 million, or 6. Because that downside protection is _worth something_ so those preferred shares by rights, are worth more than common.
kelnos 9y ago
> They basically shift a lot of downside risk from the preferred share owners (usually a VC firm I guess) to the founders and employees in the startup, which in theory makes them more likely to invest in more startups. But in the long term, this seems like it consolidates captial (which is generally a bad thing IMO). I'm torn on this. I agree that, in general, capital consolidation isn't a good thing. But you have to consolidate somewhat. If a startup founder has to deal with 100 separate investors to put together enough cash for an A round, that's a huge problem. Consolidation of some amount of capital into VCs helps with that. The VCs, when it comes to money, are also taking on much more risk than the option-granted employees are taking on. As a sibling poster mentioned, though, you really need to make a distinction between participating and non-participating preferred stock. The former is super bad for founders and employees, but these days it seems like the latter is the norm, except for perhaps in medical/biotech startups. It gives the VC a better chance of recouping their initial investment in the case that the company sells for an unfavorable amount. If the company is successful, they'll almost certainly convert their shares to common and take no more of the pie than they're entitled to.

deleted 9y ago

[deleted]

conanbatt 9y ago

I made another comment about them below, but i will repeat in a different way. People have their own assessment of what is valuable, and getting exactly what they want means they are willing to part with as much utility. A person that loves sandwiches with blue cheese is willing to pay more for that cheese than he would with the a regular sandwich. The existence of blue cheese sandwiches is moderately irrelevant to the existence of regular sandwiches. And banning them would only increase the price of regular sandwiches and also make those people less happy. Less sandwiches would be sold. Preferred shares don't really hit common shares. If you knew exactly how it went, then you would make an assessment of the value of the shares as they are. Your internal valuation of sandwiches will adjust to the existence of blue cheese sandwiches. The reason why they feel unfair, and they are unfair in this sense, is that the guys with preferred shares know what they are getting, and you dont. And also, as an employee you dont get to buy preferred shares. If you dont know the price of blue cheese sandwiches and you can't buy them, you will find them unfair. Banning sandwiches is not the solution to the problem.

GeneralTspoon 9y ago
I'm not so sure about the analogy, but I get your point. I think you're right that transparency is a big problem here. As long as others have perfect knowledge of the situation, they can factor the extra risk into their negotiations (e.g. Ask for more equity, because common shares are worth less if there are others with preferred shares). The terminology surrounding this is quite misleading too - as you mentioned in the grandparent, having 1% of a company sold for 1M, doesn't mean you'll get 10k, which is pretty weird. Not sure what the solution is though - maybe it's just for everyone to be aware of how preferred stock works and make the cap table public. It would also be nice if there were a standardised way for a company to say "We won't offer preferred stock for at least X years". Something like that would make me much more confident in taking equity in a company. Which, in principle, is actually what I want to do - but all these kinds of tricks essentially mean I can't (because I can't properly estimate the value of what I'm offered). Public cap tables would help, but wouldn't protect against future investment rounds with preferred shares.
- conanbatt 9y ago
  If it were of public knowledge that when a company IPO's, employees in total collect less than 10% of the gains, the public outrage would soon ban the practices that we see everyday. Today we have a lottery where we dont know the winners and so they are protected. I dont have animosity against investors for protecting their gains, that is fine (for them, ofc, but they are reacting to their incentives). The main reason cap tables are hidden is because the only person that can buy shares is an accredited investor, which means the company has to cater to them, not to capital. If you as an employee were able to buy and sell the shares with liberty, companies would almost immediately make cap tables public to get cheaper funding from the general public. Suddenly, investors capacity to ask for things like privacy and preferred shares would dissipate: there are millions of employees in the bay area alone that would pour considerable money into it. Increased capital means less concentrated gains, larger absolute gains, considerable increase in wages and overall greater investing efficiency.
  - kelnos 9y ago

eldavido 9y ago

It isn't absurd. You need to distinguish between participating and non-participating preferred. Participating preferred is a lot worse than non-participating, which is always converted into equity in the success case. The scenario this is trying to block is that entrepreneur raises $1mil for 10% of the company, and it's flipped tomorrow for $5mil. The investor gets 500k=50% loss in one day. It's completely reasonable and fair IMO that an investor should want protection in this case. What's not reasonable is the way silly SV journalists treat preferred as equivalently-valued as common. It's not, it's worth a lot more, making it incorrect to say that "10% of company is 1 mil => whole company worth 10 mil" when that 10% is preferred. It's probably more like 5 million, or 6. Because that downside protection is _worth something_ so those preferred shares by rights, are worth more than common.

kelnos 9y ago

> They basically shift a lot of downside risk from the preferred share owners (usually a VC firm I guess) to the founders and employees in the startup, which in theory makes them more likely to invest in more startups. But in the long term, this seems like it consolidates captial (which is generally a bad thing IMO). I'm torn on this. I agree that, in general, capital consolidation isn't a good thing. But you have to consolidate somewhat. If a startup founder has to deal with 100 separate investors to put together enough cash for an A round, that's a huge problem. Consolidation of some amount of capital into VCs helps with that. The VCs, when it comes to money, are also taking on much more risk than the option-granted employees are taking on. As a sibling poster mentioned, though, you really need to make a distinction between participating and non-participating preferred stock. The former is super bad for founders and employees, but these days it seems like the latter is the norm, except for perhaps in medical/biotech startups. It gives the VC a better chance of recouping their initial investment in the case that the company sells for an unfavorable amount. If the company is successful, they'll almost certainly convert their shares to common and take no more of the pie than they're entitled to.