Except that it almost never actually goes that way. Instead what you get is .5% of a $5M company which has a $3M preference for the latest investor, leaving you with .5% of $2M, or exactly the same thing. Except more complicated than that.
That would be uncommon in my experience. Investors won't get the difference between the current and the last valuation as a liquidation preference, they'll typically demand one as high as their investment. Understandably, they don't want to throw in a million, get 20% of the company only to have the company disband and receive 20% of the $1m back.
The $5m won't come from a $3m investment, though. They'll take 20% for $1m, leading to a $5m valuation. And I don't know anyone that would give them a $3m liquidation preference in that deal. If your cash-on-paper (that is: shares vs total valuation) share doesn't grow in a round, that's a good time to think about getting out. If they were valued at $5m and are seeking investments valuing the company at $2m, run.
Yes, investors aren't throwing money around like they maybe used to, but I don't believe there's reason to be overly pessimistic. If the company becomes successful, you'll make money if you've been on board early enough (that is: if you took on risk).
