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Before you join the next "exciting, top venture capital firms backed" start-up, you need to understand liquidation preference and preferred participation. As I wrote in Don’t get screwed! Startup questions you should ask before you  join a startup — you could totally be screwed by a start-up. You need to know the details of the start-up’s financing structure to protect yourself. If the start-up refuses to share the details with you, you shouldn’t join the company.

Today, I would like to share with you a real world case study that explains the concepts of liquidation preference and preferred participation.

I’m not a lawyer. I’m giving you a very simple example. My intention is to get you started and give you a basic understanding. For a thorough, authoritative discussion of legal aspects of start-up financing, please read the excellent The Entrepreneur’s Guide to Business Law. In fact, I think this book is a must read for anyone who plans to start a business or join a start-up.

Liquidation preference is a legal term used by venture capitalist to protect their down side risk. They wanted to at least get their money back. Liquidation preference is very common. The most common term is 1x of venture capital investment.

Preferred participation is another device used by venture capitalists to protect their down side. It is sometime referred as "double dipping".

Let me give you an example to illustrate.

Startup X just received 3rd round of financing. Prior to the financing, Startup X is valued at $8 million dollars. Venture Capitalist put in $2 million dollars. So, right after the financing, Startup X has a post-money valuation of $10 million dollars. After the 3rd round of financing, venture capitalists owns 80% of the company, founders and employees own 20% of the company. venture capitalists have a liquidation preference of $8 million, and preferred participation of 3X liquidation preference ($24 million).

Also, in most startups, venture capitalists own preferred stocks, while founders and employees own common stocks. This means venture capitalists will get their money first before everyone else when an exit event such as acquisition takes place.

Let’s go through 3 scenarios: Bad, OK, and Home Run.

Scenario #1: Bad outcome for Start-up X. The company was crushed by competition. It’s sold for $6 million dollars.

Venture capitalists have two options:

Option #1: Venture capitalists can convert all of their stocks to common stocks. Since they own 80% of the company, they will get $6 million X 80% = $4.8 million. Founders and employees will get $6 million – $4.8 million = $1.2 million.

Option #2: Venture capitalists chooses to take advantage of liquidation preference. Since the liquidation preference is  $8 million, and the company is sold for $6 million, the venture capitalists get the entire $6 million. Founders and employees will get nothing.

Obviously, venture capitalists will choose option #2 in this scenario.

Scenario #2: OK outcome for Start-up X. The company did OK, but had limited growth. The company is sold for $18 million.

Again, Venture Capitalists have two options.

Option #1: Venture Capitalists convert all of their stocks to common stocks. Since they own 80% of the company, they will get $18 million x 80% = $14.4 million. Founders and employees will get $18 million – $14.4 million = $3.6 million.

Option #2: Venture Capitalists choose to take advantage of liquidation preference and preferred participation. They will get:

• $8 million due to liquidation preference
• Because of preferred participation, they will be able to "double dip" for the remaining money up to the $24 million preference participation cap: they will get ($18 million – $8 million) * 80% = $8 million
• $8 million + $8 = $16 million, which is less than the $24 million preferred participation cap. So, venture capitalists will get $16 million.
• Founders and employees will get $18 million – $16 million = $2 million.

Obviously, venture capitalists will choose option #2 because they will make $1.6 million more.

Scenario #3: Home run outcome for start-up X. It’s sold for $100 million.

Let’s review the two options venture capitalists have.

Option 1: venture capitalists convert all of their stocks to common stock. Since they own 80% of the company, they will get $100 million *80% = $80 million.

Option 2: venture capitalists chooses to take advantage of liquidation preference and preferred participation. They will get

• $8 million due to liquidation preference.
• Due to preferred participation, they will double dip. ($100 million – $8 million) * 80% = $73.6 million. However, due to the preferred participation cap of $24 million, venture capitalists can only get $24 million in total, including the $8 liquidation preference.

Obviously, it makes much sense for venture capitalists to choose option 1 since they will make a lot more money by converting their preferred shares to common shares. This example demonstrates that liquidation preference and preferred participation are used to protect down side for venture capital investment.

Liquidation preference is very common — almost every venture capital backed start-up has it. However, preferred participation is something entrepreneur would fight very hard to avoid. In today’s economic environment, it’s not uncommon to see 2X or 3X liquidation reference for preferred participation term, which is pretty bad from entrepreneur and employee perspective.

Today’s market is drastically different from the dot com days. Big acquisition or IPO are rare. It becomes even more important for employees to understand the financing terms to make a realistic assessment of the start-up.

Related posts

• IPO shouldn’t be the goal for a start-up
• Too many managers, too few leaders
• Is starting a company in Silicon Valley stupid?
• You must be a lazy man if it takes you ten hours to do a day’s work

Excellent resources

• The Entrepreneur’s Guide to Business Law
• The Art of the Start: The Time-Tested, Battle-Hardened Guide for Anyone Starting Anything
• From Alchemy to IPO: The Business of Biotechnology
• High Tech Start Up, Revised and Updated: The Complete Handbook For Creating Successful New High Tech Companies

I recently bought a new car. I had to admit that I hate to deal with car salesmen. It was one of my least favorite activities.

Unfortunately, I needed a car. And I didn’t want to get ripped off. So, I was determined to get a good deal while minimizing my pain. Here are 11 lessons I learned from hard-nosed negotiation with car salesmen.

1. Start price negotiation below invoice price. Dealers will tell you that they cannot sell you at invoice because they will not make any profit. Never believe what dealers tell you. They will make money if they sell the vehicle to you at invoice price because of dealer hold-back. My initial offer was $800 below invoice. Everyone thought I was crazy. The car salesmen laughed at my offer. But, I had done plenty of research online. I knew the market. Trust your data. Don’t let other people’s opinions and negotiation tactics sway you.
2. Set an one-hour time limit when you walk into a car dealership. This is a common tactic used by every car salesman I talked to: I made an offer. They said that they needed to talk to their manager. They then disappeared for 20 to 30 minutes. They would finally came back and said that they couldn’t take the offer. They asked for a compromise. They would then repeat this process. They wanted to make the negotiation process as time-consuming as possible so that the customer would give up in the end. Don’t fall into this trap. When you walk into a car dealership next time, tell them that you will only have an hour to talk to them. You must leave in an hour.
3. Plan two weeks of time to purchase your car. — test drive your desired vehicle in the middle of a month, but wait until the last few days of the month to purchase the vehicle. Car salesmen have monthly quota. You’re likely to get good deals in the end of each month. I bought my car three days before end of the month, and got a pretty good deal.
4. You should research car data on multiple auto web sites and forums. Don’t trust a single source. I mostly used Edmunds.com, and TrueCar.com. I also frequented Edmunds.com’s message board to check actual paid price reported by users in my area. TrueCar.com is a fairly new site, but it provides very useful reports of actual price paid by customers in your area. However, you should still cross check data across multiple sites.
5. Car dealerships don’t expect to make a lot of money from new car sales. Most car salesmen will tell you that they cannot sell you a new car at such a low price because they have a big building with a lot of employees and the owner has to pay the bills. But, they will not tell you that car dealerships make most of their money from used cars sales. They don’t make much money from new car sales since the prices for new cars are much more transparent. If you’re buying a new car, don’t let this argument sway you during negotiation. 
6. Don’t buy cars from a dealership with fancy building and flashy advertisements. One dealership I visited has a super nice building. It has a young lady whose job is to serve free coffees/cookies/drinks to customers. It’s really nice. But, someone has to pay for the ambience! If you’re a value buyer like me, stay away from those fancy dealers. They will charge you more. 
7. You can do much better than the Costco auto buying program. A common negotiation tactic I encountered at almost every single car dealership was that they would offer me the Costco car buying price as the lowest price. They said that it’s backed by Costco. It’s non negotiable. Since I’m a value buyer, it’s the best program for me. In my opinion, the Costco auto buying program is being abused by many dealers. Costco is damaging its brand by partnering with dealers. My advice: never buy a vehicle at Costco price. You can do much better than the Costco price.
8. Cut the price for dealer-installed options by at least half. It’s very likely that the dealer has installed several options on the car. Tell them you don’t want these options. The price they quote you will give them 50% or more margin. You can easily cut it by half, if not more.
9. Find yourself a good car salesman who takes care of customers. I once heard a quote: "when did car salesmen lie? When they moves their lips." However, there’re good car salesmen. They tend to stay at the same dealership for five years or more. They have established a happy customer base who will go back every few years to purchase cars from them. You should ask around for referrals. A good car salesman will make the purchase process much easier for you.
10. You want to be a tough negotiator, but not an unreasonable negotiator. Remember that car salesman needs to make a living as well. You should give them a reasonable margin, which is about 3-5% for new cars. 
11. Don’t negotiate for pennies. Here is the formula I used: if I can save $600 for two-hour negotiation, I’m making $300/hour, which is much higher than my paycheck rate. However, if I spend a few hours to save $100, it doesn’t worth my time. Keep your perspective during negotiation.

Related posts:

• Will you still buy Toyota?
• My "Rich Dad, Poor Dad" lesson on New Year Eve: How one family with $70K annual income owns five houses in the San Francisco Bay Area
• Should parents pay for the full amount of their kids’ college education expenses?

Excellent resources:

• Bargaining for Advantage: Negotiation Strategies for Reasonable People 2nd Edition
• Getting to Yes: Negotiating Agreement Without Giving In
• Getting Past No

This is a serious problem. It’s more common than you might think.

It’s heart wrenching for the parents and siblings. No matter how accomplished and wealthy they are, they feel powerless in dealing with this problem.

In the past few years, directly and indirectly, I have known several families who are facing this very difficult problem.

All of these families have an adult son or daughter who is in his or her late 20’s or early 30’s. They share a common pattern.

• They have all been good kids when they grew up. They were good students, and graduated from good colleges. Most of them attended prestigious Ivy Leagues schools or small liberal art schools.
• After college, they moved around low-paying jobs, but they never found the jobs they really liked.
• They held a belief that they didn’t want to "sell out"; they wanted to pursue their passion.
• They also had a notion of living certain life styles because they all grew up in middle-to-upper class families.
• When the economy was going south, they had a even harder time to find a job. They moved home to stay with their parents.
• They have been jobless for two years or even longer. 
• They got monetary help from their parents and occasionally from their siblings. They’re not starving by any stretch, but they’re dependent on their parents.

Most of them are not even actively looking for jobs. When opportunities knocked at their doors, they usually would say things like "it’s not something I’m passionate about", or "it sucks. I don’t want to work in that environment", etc.

They’re confused, aimless, and just hanging out with a few friends who are in the same boat.

The parents and siblings are worried, frustrated, and angry — they hate to see their precious son, daughter, brother, or sister to waste away.

I’m neither a psychologist nor a social scientist. I could only offer hypothesis about what is going on based on what I knew about the families I talked to.

I think most of these families have provided an over protected environment to their kids. Almost all of the families are well off, and they tried to provide everything to help their kids to succeed. The kids had lived a very sheltered life.

The kids didn’t disappoint their parents. They did well in school. Until graduating from college, it was a pretty smooth ride for the son or daughter.

But, that’s where the problem started. They had experienced very little setback in their lives. Things came too easy to them.

As a result, they were not prepared to face the harsh reality in professional environments. They lacked the mental toughness and street smart to navigate the real world.

Additionally, they grew up during a period of unprecedented economic prosperity. They were not prepared for the sharp economic down turn, and the difficult job market.

I was chatting with a college friend of mine. One thing he mentioned to me was really interesting: we both went through a very competitive environment at UC Berkeley. One thing about attending a large public school like Berkeley was that nobody really cared about you. You had to take care of yourself; otherwise, you’d drop out. There was a grading curve for most classes at Berkeley, which means certain percentage of student would flunk the class. We were conditioned to work really hard, rely on our ability, and survive. Some people really disliked that environment. Unlike a private school, Berkeley was pretty rough. But, we felt that we acquired the mental toughness from that experience.

I think the point is that adversity really helps young people to build characters and mental toughness. These attributes become increasingly important as we navigate our career and life after college. 

I also think the phrase "pursue one’s passion" is way overblown by media and self help gurus.

Don’t make me wrong — I’m an idealist in my heart. I have wanted to be a writer since I was third grade. My ideal job is to write, read, and teach full time. That’s why I have been diligently working on this blog because I really enjoyed it. But, I also have a full time job in high tech because I need to survive and support a family.

Instead of blindly pursuing one’s passion, I think Abraham Maslow’s Hierarchy of Needs provides a more balanced and pragmatic paradigm.

Do you know any never grow up, jobless, and confused young adult? Do you have any ideas to help them? I would love to hear from you.

Related posts

• You’re too sensitive!
• The anti dot com path to success: A different way of living and working
• Don’t get stuck
• The first time I cried at work

Excellent resources

• Quarterlife Crisis: The Unique Challenges of Life in Your Twenties
• Conquering Your Quarterlife Crisis: Advice from Twentysomethings Who Have Been There and Survived (Perigee Book)
• The Overachievers: The Secret Lives of Driven Kids

The Secret of Profitability (SOP) is a high profile start-up in the Silicon Valley.

It’s "high profile" because

• it has two of the most famous venture capitalists on earth sitting on its board.
• it had received $100 million in venture funding.
• its senior management consists of super stars from major internet companies such as Google and Amazon, top-tier strategic consulting forms such as McKinsey & Company, prestigious universities such as Stanford and Berkeley, etc.
• It has been selected by major publications as "top 100 start-up super stars", "The next Google", "The 21 Century Top Digital Company", etc.

SOP’s goal is to make one product: it offers a "secret sauce" — its scientist have figured out a way to apply artificial intelligence technology to make any start-up become profitable instantly. It holds the secret of profitability.

But, SOP has one problem: it is not profitable itself. In fact, it doesn’t even have a product yet.

SOP had four rounds of funding. Its senior management team had changed three times. About one year ago, the company hired its 4th CEO. He had done a good job to turn around the company. Product development is on track. Initial beta test of the product had very positive results. SOP seems to be finally turning a corner.

SOP still has some cash left in the bank. But, the CEO wants to launch a very aggressive marketing and sales push. He wants to beef up his cash position so that he can take SOP to the finish line as soon as possible. His goal is to make a lot of money quickly.

To make the aggressive marketing and sales push, the CEO has decided to raise 5th round of funding. He’s already gotten verbal commitments from several venture capital firms.

But, he ran into a problem. A couple of years ago, when the company raised its 4th round of funding, to protect employee’s stock options, the management put in a "poison pill" — in the future, if the company wants to get more funding that will further dilute the employee options, the financing must be approved by employees that represent 70%+ of the total number of employee stocks.

The CEO’s challenge is to get the required votes from employees to approve the 5th round of financing.

The shrewd CEO worked with CFO and legal counsel to come up with a game plan. Instead of calling a company-wide meeting that include all employees, he identified a group of employees who are close to him. Most of them are managers or above. And they represented a little bit over 70% of the total employee stocks.

The CEO gathered these people in a small room. He told them that in order to approve the financing proposal, everyone in the room had to vote "yes". If the financing proposal didn’t get pass, then the proposal will be presented to the entire company to approve, which would significantly delay the financing process.

Pretty much everyone in the room voted "yes" — they knew that they had no choice. The company might go under if they didn’t vote "yes". But, they all felt pretty bad — they wonder why they had such a secret meeting. Isn’t every employee shareholder equal? Why were we invited to this meeting while some colleagues were not invited?

In my opinion, the CEO is not very ethical. All employees should be invited and given a chance to vote.

I’m not a legal professional, but I wonder if this is even legal — this is like the United States has a presidential election, but only certain people are allowed to vote initially.

This post is a fictional account, but it’s based on true stories. I’d like to hear your take on this story: is the CEO’s action ethical? Or even legal?

Related posts:

• Don’t get screwed! Stock option questions you should ask before you join a start-up
• IPO shouldn’t be the goal for a start-up
• Is starting a company in Silicon Valley stupid?
• If I can pick and choose any start-up to work for, I’ll pick … Part 1

Excellent resources:

• The Entrepreneur’s Guide to Business Law
• Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur
• Raising Venture Capital for the Serious Entrepreneur

Jake called me yesterday morning. He informed me that he just gave notice to his boss. He was leaving his employer. Jack called me because I was one of his customers, and we had collaborated for the past three years.

Jake was a member of the senior management team in his company. On the surface, he got along really well with the president. They worked together at another company before they both came to work for Jake’s current company.

Jake told me that his last day would be two weeks from yesterday. In the high tech industry, the "norm" is for employees to give at least two-week advance notice.

Jake emailed me this morning at 5AM. Today is his last day.

Yes, he is supposed to be in good terms with everyone in the company. He doesn’t have any performance issue. His team has been performing well. He is a member of the senior management team. He did the right thing by giving two-week notice. But, he was still asked to go immediately.

I’m NOT surprised. For most of us, unless you belong to an union, the employment contract you sign is at-will. Either employer or employee can terminate the contract at any time. The two-week advance notice is a common courtesy, but employers are NOT required to honor your courtesy and professionalism.

When you offer your resignation, you really don’t know how your employer will react. You need to protect yourself. You need to expect the worst.

So, before you offer your resignation, you should be ready to leave immediately.

You should clear out your office, save contact information, and clean up your computer.

You should be ready to leave the second you tell your boss that you’re leaving.

Related posts:

• Quit early, and quit fast
• Seizing the enemy without fighting is the most skillful
• The clear and present danger of internal transfer
• The dirty secrets of performance review

Excellent resources:

• Corporate Confidential: 50 Secrets Your Company Doesn’t Want You to Know—and What to Do About Them

It’s All Politics: Winning in a World Where Hard Work and Talent Aren’t Enough

Every Employee’s Guide to the Law

Fired, Laid Off or Forced Out: A Complete Guide to Severance, Benefits and Your Rights When You’re Starting Over