Why do later rounds of investment get senior liquidation preference?

The short answer is “because the later stage investors can demand it” (i.e., the golden rule) but there’s more to it than that.

The liquidation preference can be considered a protection mechanism; it’s not primarily a way to reward risk-taking. If you understand what scenario it’s protecting against, the logic will become clear.

Suppose you’re the first investor in a new venture. On the date of close, you wire $5m to the company and receive 30% of the shares. The next day your new “partners” sell the company for $5m to a dummy corporation. You get 30% of $5m, or $1.5m. The dummy corporation gets the $5m on the company’s books, plus whatever other assets exist.

You: $5m in, $1.5m out

Unscrupulous entrepreneurs: borrow $5m, receive $3.5m from the “buyout”, repay the loan with the $5m on the company books. $0 in, $3.5m out, depending on how much they have to pay in interest to borrow $5m for a few days.

Variations exist. The founders could just call it a day and liquidate the company, distributing the assets to shareholders: you’d get $1.5m (or less) that way too. The dummy corporation could even be a legit buyer who’s made a lowball offer that for some reason company management wants to accept. Their interests aren’t aligned with yours.

Now, the same thing applies if you’re the fifth investor, looking at a series E round. Without the liquidation preference, the new cash you’re putting in could end up spread among the existing investors, whether it’s through a sale or liquidation. “Last-in first-out” preferences means this is impossible. The only way the other investors can extract cash from a liquidity event is by making you money, too.

Originally answered on Quora: https://www.quora.com/Why-do-later-rounds-of-investment-get-senior-liquidation-preference-What-is-the-logic-behind-later-stage-investors-getting-paid-first-if-theoretically-earlier-stage-investors-took-more-risks/answer/Mark-Gritter