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As someone who is reasonably familiar with term sheets, I feel embarrassed that I never gave much thought to the moral hazard that liquidation-preference clause

As someone who is reasonably familiar with term sheets, I feel embarrassed that I never gave much thought to the moral hazard that liquidation-preference clauses create. Viewed from the perspective of a founder, they are a serious annoyance. But from the perspective of the public at large, they are being exploited to engage in pseudo-fraud. Right now, the world treats a company's 'valuation' as a reliable signal of information about how much investors actually believe the company is worth. That information is then integrated into heuristics that influence various people's decisions: Will a paper write about a startup? Will a reader pay attention? Will a recruit take the company seriously? A billion dollar valuation goes a long way in each circumstance. The problem is that our collective intuitions are using an outdated algorithm for assessing value. In theory, VCs who invest at a given valuation are providing reliable information by putting their money where their mouth is. But in practice, liquidation preference means that the official valuations attached to their deals don't really reflect the limited risks they are taking on. A VC who invests $10 million at $1 billion valuation may officially be signaling to the world that a company is valuable. But if he insists on a two-times liquidation preference, then he is really indicating that when the whole thing blows up he wants to make sure he can get the first $20 million. Unfortunately, that information isn't broadcast the same way to outside decision makers. Even those of us who think that startups are grossly overvalued don't give enough thought to how illusory those valuations are to the very investors whose capital is fueling them. I hope that will start to change.

ghshephard 11y ago
That same VC is only getting 1% of the company if they value it at $1B pre-money - that's the flip side of a high valuation - the higher it is, the less ownership the VC gets.
- ClintEhrlich 11y ago
  True. The question is how much the VC thinks that accumulated advantage (in sociology, "the Mathew effect," according to which the rich get richer) means that an increased present valuation can increase the probability of future increases in value. And if the VC thinks that the upside is big enough — e.g., the next Uber — then 1% equity could be worth a billion dollars in the foreseeable future. The trick to black-swan farming is casting a big enough net. And liquidation-preference makes it possible to take more bets by significantly decreasing downside risk on each one. Obviously, we are aren't dealing with a linear relationship. Once companies reach a certain valuation, the prospects for future growth are significantly reduced. But there may be an intermediate stage where the benefits to the company are significant enough that the VC's probable ROI increases by investing at a higher valuation. A VC who really wants to game the system should make a large seed investment at a low valuation, and then make smaller investments in later rounds at intentionally inflated valuations.

ghshephard 11y ago

That same VC is only getting 1% of the company if they value it at $1B pre-money - that's the flip side of a high valuation - the higher it is, the less ownership the VC gets.

ClintEhrlich 11y ago
True. The question is how much the VC thinks that accumulated advantage (in sociology, "the Mathew effect," according to which the rich get richer) means that an increased present valuation can increase the probability of future increases in value. And if the VC thinks that the upside is big enough — e.g., the next Uber — then 1% equity could be worth a billion dollars in the foreseeable future. The trick to black-swan farming is casting a big enough net. And liquidation-preference makes it possible to take more bets by significantly decreasing downside risk on each one. Obviously, we are aren't dealing with a linear relationship. Once companies reach a certain valuation, the prospects for future growth are significantly reduced. But there may be an intermediate stage where the benefits to the company are significant enough that the VC's probable ROI increases by investing at a higher valuation. A VC who really wants to game the system should make a large seed investment at a low valuation, and then make smaller investments in later rounds at intentionally inflated valuations.