Not my field - but it was talked about recently here. I'll do my best, but help me out here guys...
Essentially, the money VC invests can be invested with a 'first-out' kind of option. So that were the company to fail, or sell for less than expected, that the very first people paid out of whatever pot of money is left would be the VCs. So imagine they say the company is worth $1B and a VC put in $200M. Company sells for a 'dismal' $210M. VC exits with their $200M back, and founders, team, other investors etc. all fight over the $10M that on paper seemed like $800M. As I recall, sometimes the investments are not just 'preferred' but are '2x preferred' or such things.
In the end it distorts the incentives of the VC. The want the company to be worth a billion dollars, but if they say it, it's not true, the company crashes, and loses nearly everything, they in reality only lost the time-value of their investment, not actually any cash.
Essentially, the money VC invests can be invested with a 'first-out' kind of option. So that were the company to fail, or sell for less than expected, that the very first people paid out of whatever pot of money is left would be the VCs. So imagine they say the company is worth $1B and a VC put in $200M. Company sells for a 'dismal' $210M. VC exits with their $200M back, and founders, team, other investors etc. all fight over the $10M that on paper seemed like $800M. As I recall, sometimes the investments are not just 'preferred' but are '2x preferred' or such things.
In the end it distorts the incentives of the VC. The want the company to be worth a billion dollars, but if they say it, it's not true, the company crashes, and loses nearly everything, they in reality only lost the time-value of their investment, not actually any cash.