Well, selling the company for the post-money valuation will give the investors their $X back. The thing that the liquidation preference works is preventing certain types of control fraud.

For example, if the founders take $1M in funding on a $2M post-money valuation, then end up losing $1M to excessive payroll costs to insiders and sell the remnants of the company for the pre-money valuation, the investors are out half their money without a liquidation preference. In short, the liquidation preference means that any losses come out of founder equity first, rather than the new cash infused in the business. This is important because the founders control the company and can choose to take courses of action that impoverish the company at their personal benefit.

Right, that's an example of the scenario I was referring to and why I pointed out that in the scenario we're talking about the founders retain control of the board.

The broader point is that investors should eat the same dog food as the founders and early employees, including when it comes to common shares and no liquidity preferences. The fairness point you asked about includes removing preferred shares, you're splitting it as though I was only talking narrowly about an issue of a 1x preference. I fundamentally disagree with start-up investors receiving preferred shares as a norm.

I think YC should take the lead in trying to strip liquidity preferences from the industry. They should become non-standard in most term sheets. Ideally they advocate up the chain further by leveraging their considerable influence to water down or eliminate liquidity preference whenever possible. YC has been a founder-friendly venture firm from the beginning, I believe one of the best pro-founder fights for them to pick is to work toward ending the standardization of liquidity preferences. It's currently backwards, liquidity preferences should be rare.

I can't tell what you're saying here. You say I'm focusing too narrowly on the 1x preference, but then go on to say you disagree with preferences at all. I asked: how does a VC deal with no contractual investor protection work? You could be giving up $X in exchange for contractual rights to only $X/5 in a sale that occurred the next day. That's not a moral problem, it's a math problem, right?

Query whether this needle can't be threaded by allowing the board to waive liquidation preferences, so long as the investor board member(s) approve. I agree with you that a certain level of investor protection is needed to prevent fraud (obviously there's the threat of a lawsuit for breach of fiduciary duty, but there are many reasons why that would not be a reasonable substitute for a liquidation preference).

The question I have is when the founders have acted in good faith and the company goes downhill, should the founders bear all the downside risk there?

I can see someone saying yes - if the company goes south, everyone should get the money they invested as shareholders back. But that's a different argument.

An additional question I'd ask - is some method of waiving liquidation preferences by the board (again, including the investor board member) a good idea from the perspective of aligning incentives?

Let's say the company has seen a downturn where there are two options at play: a sale at a value that would give the founders nothing, after the liquidation preference is exercised OR a risky (but legally defensible) Hail Mary business plan to bring the company back from the brink.

If the founders get nothing out of the sale, aren't they incentivized to choose the Hail Mary option? (Obviously there are other opportunity costs for the founders.) If the liquidation preference could be waived by the board, then that would give the founders an incentive to approve an "efficient" sale.

Note: I am suggesting the idea of the board approving the waiver, as opposed to the preferred shareholders, so that the waiver applied across the board to all preferred shareholders. And the investor board member would have to vote in the best interests of the company when voting in the role as a board member, as opposed to in their own self interest, which they do as a preferred shareholder.

All that being said, I don't think liquidation preferences are the place to focus on making "standard" term sheets more company friendly. I could write a lot about that...

This term sheet is a fair distillation of fairly standard terms. I think what adventured is looking for is something that moves the Overton Window as to what's "standard." I don't think YC was purporting to play that role here.

With organizations like the NVCA playing such a pivotal role in the terms of VC financings, I think it is critically important that thought be given on the founder side towards advocating more founder-friendly "standards."