In defence of liquidation preferences

I just read a New York Times article that led with the sentence “Deep inside a Silicon Valley unicorn lurks a time bomb”. It turns out that ‘time bomb’ is the much maligned and, I suspect, little understood, liquidation preference.
To be clear, liquidation preferences are sometimes used badly and founders should generally turn away from investors who ask for multiple liquidation preferences. Additionally, they introduce a small amount of complexity and an element of misalignment between the investor and the common stock holder (usually the founder).
For these reasons our investments at Forward Partners are always in ordinary shares.
However, most of the later rounds or companies raise feature simple 1x liquidation preferences and we’re fine with that. To explain why I’m going to look at the role liquidation preferences play in getting deals done.
In any negotiation it’s helpful to look for ways in which the counterparties see things differently to reach other. These differences create the space for win-win solutions and without them negotiations are a zero sum game.
Liquidation preferences are a useful tool because they exploit a difference in the way investors and management see the future. Generally speaking management teams have more confidence in their success than investors do. Not by much, but by enough that it makes sense for them to accept a liquidation preference in exchange for a higher valuation. That trade gives them less dilution and therefore more cash in upside scenarios but less cash (and potentially nothing) in extreme downside scenarios.
This trade off is now so entrenched that it’s become a market standard that most investors and founders make unconsciously, but they are all aware of the implications. Moreover, in the rare situation where investors offer a choice management almost always go for the higher valuation.
Furthermore, provided the instrument is kept simple (i.e. a 1x non-participating preference share) and the company is successful enough to raise a couple of million or more the complexity and misalignment are more than manageable. Then as companies get towards unicorn status management and investors get increasingly sophisticated and their ability to exploit more complex instruments increases.
None of this is to say that some companies haven’t been overvalued and that liquidation preferences haven’t contributed, but it doesn’t sound like a ‘time bomb’ to me.