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