Liquidation Preferences and Why They Matter for App Developers

December 26, 2016 - 3 minutes read

Founders tend to be a passionate group focussed strongly on the nuts and bolts of their product or service. When it comes time to raise venture capital, it’s easy to just say “yes” to anything and everything that presents itself. The problem is that shares of a company aren’t all created equal, and startups often wind up in a position where venture capitalists have more security than the employees, or even the founders themselves.

The culprit: liquidation preferences. Bad deal? Not necessarily — only if the app developers in question don’t know what they’re getting into.

Stock for a startup comes in two basic flavors: “preferred” and “common.” As you might guess from the names, preferred stock has some compelling advantages over common stock. Specifically, it guarantees that investors get first dibs on any assets the company might have if it goes bankrupt, closes down, is sold, or merges with another company. It’s common for startups these days to be structured such that equity returns “trickle down” from the VCs to founders to stakeholding employees or app developers in the event of failure.

During the tech boom of the late 90s, it was common for investors to get preferred stock with a guarantee around 1x the value of their investment. This is similar to a loan, where there’s collateral to “repossess” if a deal goes wrong. Once the high risks of the tech market became evident, however, investors began demanding much higher protections on their shares, up to ten times the value of their contributions.

Why do startups offer this sort of stock deal? In short, because the high risks can make it tough to find VCs otherwise. Needless to say, hot young companies with huge potential are able to avoid doling out preferred shares if enough investors are rushing to get a piece of the pie. Ultimately, funding app ideas comes down to negotiation. If a founder isn’t as good at the nuts and bolts of negotiations as they are at building their product, they’re best advised to partner with someone who is. After all, it’s better for NYC app developers to share the company fairly with someone close than accidentally with eager investors.

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