The Harsh Reality Of The Preference Stack

I recently shared this article and tweeted this, and I was quite surprised by the thread it triggered and the reaction it generated. After reflecting on it for a day, I began to understand why — even though this topic has been written about many times, “technology” as a sector and industry now has gone from vertical to horizontal, entirely pervasive across industries, across sectors, across geographies and cultures. And with this, every year, a new cohort enters into the “tech startup” world, and there’s no official canon to read, no “one-stop shopping” site or user manual to get briefed on the things you absolutely need to know.

So, that’s why I’m writing this short post specifically for 1) employees of early-stage startups and 2) the earliest investors in these startups, who are often themselves new to the entire sector. And as a disclaimer, 1) I am figuring this out myself in real-time. Maybe I have a 1-2 year headstart. And 2) things may vary on a case by case basis, so rather than get lost in nuance here, I want to keep this post short, sweet, simple, and entirely accessible to everyone — I view this as “must-know information.”

For brief context, how did we get here? The private markets have ballooned, and the VC model is based on building a portfolio of companies such that the best ones can be acquired or go public. While companies today can still go public and get acquired, those events are quite rare relative to the explosion in new startup formation. That can seem dire, but the new age also presents opportunities in hotly-contested secondaries.

For employees at early-stage companies… the equity you’ve been granted is likely options for common stock in the future “stock options,” just like the founders. You can read more about the types of stock granted in startups here. If the startup you’re working at begins to raise lots of money, and especially if it attracts non-traditional investors to startups (private equity, hedge funds, and so forth) it’s likely those rounds could be “highly-structured” financings which is another way of saying those investors likely put terms on the financing that, in the event of liquidity, their shares will rank higher on a “preference stack” relative to others. Knowing where you sit on this preference stack is a good thing to know, so you should ask. For more reading, check out this more detailed post by Scott Belsky.

For early investors in companies… the notes you’ve converted into shares and the equity you own in startups that breakout and raise lots of money will not only likely get diluted (very few early-stage funds can defend their positions over time or grab enough ownership upfront to withstand the dilution) but also will likely get demoted on the preference stack. While folks will feel sympathy for line employees at startups who don’t make any gains in a sale, no one will feel sorry for early-stage investors who get washed out. I’m writing this to underline the point that early-stage investors should be aware of the risks of being “trampled by a unicorn” as Belsky writes, to be on top of changes to the price per share, to keep their documentation sound, and to potentially use the advent of mega-financings at huge valuations as a new point of liquidity – for example, if you invested in a company at a $4M cap and it just raised $100M at a $1.5B valuation, that’s sort of like a new IPO, but without the lockup period. (Again, things will be different on a case by case basis, but at least being aware of this will help.)

No one is forced to work at or invest in a new company. All of this activity is at-will. There is also no promise of a reward or payout. I do feel, however, we are in a unique time as it relates to capital 1) in the market and 2) focused on technology — and this has created never-before-seen conditions, mega-financings from traditionally public or indirect investors. This trend has created new challenges but also some new opportunities. There will be more stories to follow of high-flying startups that find a home where some people will make money and others won’t, and this will be especially jarring for folks who see their colleagues get paid while they don’t. To put on twist on a famous line, you’re either at the table for the most recent mega-financing, or you’re likely to be near or at the bottom of the preference stack.