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The analysis in this article is very superficial. Liquidation preferences do not drive up valuations. Of course, they offer "insurance" to preferred stock inve

by grellas 11y ago

The analysis in this article is very superficial. Liquidation preferences do not drive up valuations. Of course, they offer "insurance" to preferred stock investors against downside risk. But they have being so for several decades in the Valley (and elsewhere) and this has nothing to do with valuations as such. Indeed, when valuations are at their very lowest (such as post dot-bomb in the early 2000's), the liquidation preferences became so high as to be regarded as absurd (e.g., 3x or even higher). This was often coupled with the idea that the preferred stock would be participating, meaning that the investors in any M&A deal get their 1x (or 2x or 3x or whatever) back and also get to take their proportionate share of the merger consideration on the M&A deal itself. The reason there are $1B+ valuations is primarily because the VCs believe the ventures will come to dominate major areas of commerce, will typically go public with sky-high valuations, and will continue to grow and dominate even after all that. Investing $100M at $1B valuation is risky but pays hugely if the company later becomes valued at $100B+. Yet, when a company goes public, the terms of the preferred stock typically require conversion into common stock and, in that case, the liquidation preference goes away altogether and confers no benefit on the investor. In short, very incorrect analysis and not really worth reading.

ClintEhrlich 11y ago
The article's analysis may have been superficial, but I don't understand why you dispute that liquidation-preference increases valuations. As you note, it offers investors protection against downside risk. That protection allows them to safely invest at higher valuations than they otherwise would, precisely because they will be protected if those valuations come plummeting down to earth. Without that guaranteed protection, they would need to demand lower valuations. The historical examples you offered are consistent with this theory. In the early 2000s, valuations would have been even lower without liquidation preference. And it's true that the huge upside of modern startups may account for their astronomical valuations, but investors are only willing to entertain such wild risks because of the protections they enjoy from downside risk. So, liquidation preference may not be a new phenomenon, but that doesn't mean it's not important.
- philrapo 11y ago
  To put it another way, downside protection / insurance has value.
- pbreit 11y ago
  But if that rarely/never happens, the protection probably isn't as valuable as many think. I'm guessing less than 10%. So Uber still gets a $46-49b valuation.
aliston 11y ago
It's unlikely that Dropbox, AirBnb etc. are going to liquidate, so I think you're right that liquidation preferences probably aren't as big a factor in the unicorn valuations. Most of the investors in the unicorns are late stage funds hoping for an IPO. However, it's not true that the preferred stock directly converts to common stock in all cases. My guess is that almost all of these deals involve ratchets, which are definitely driving up the implied valuations. It also means that if the valuation doesn't keep going up, common stock holders take a bath. Take Box's balance sheet pre-ipo as an example.
mrwilliamchang 11y ago
I have no first hand knowledge of this, so I'm probably wrong. Maybe it's more accurate to say that the late stage investments are driving valuations up (ie the a16z analysis). But a lot of these later stage investors would not have felt comfortable without the liquidation preferences. The key distinctions is that liquidation preferences are not critical a VC's decision to invest, but are critical to the later stage large institutional investor's decision.
philrapo 11y ago
Are you saying you'd value shares at the same amount with or without a liquidation preference? I'd value the shares with liquidation preference at a premium, no contest. e.g. 1,000 total shares. You can buy 10% (100 shares) for $10mm with 2x liquidation preference included. Now say I remove the liquidation preference. Your valuation model doesn't change? Mine certainly does. I'd value the shares lower, causing a lower company valuation for the 10% of the company that's changing hands. >The reason there are $1B+ valuations is primarily because the VCs believe the ventures will come to dominate major areas of commerce, will typically go public with sky-high valuations, and will continue to grow and dominate even after all that. Investing $100M at $1B valuation is risky but pays hugely if the company later becomes valued at $100B+. It pays hugely even in a down round with liquidation prefs. I'd invest $100mm at a $1bn valuation with 2x liquidation preference, even if I thought the monetization event would occur at a $300mm valuation (down -70%). I'd still get paid out $200mm for a +100% return. If I didnt have the liquidation preference, I would've lost -70%.
- ryandamm 11y ago
  I was under the impression that anything other than a 1x liquidation preference is extremely founder-unfavorable and very rare. Am I mistaken? Are these unicorns wandering around with significant (2x, 3x) preferences attached to them? Because otherwise, a 1x only says you get your principal back. Covers the VC's butt in a down round, but nothing crazy. To the extent it comes out of founders' hide, well, you took money and didn't manage to make it grow. (The effect on rank-and-file employee options is a little less defensible, though, since they have less control over total execution.)
  - philrapo 11y ago
    I haven't seen any data on it, but that's my understanding as well. (>1x is rare in today's market). But the NYT article does mention Honest Co. with a 2x on $1.7bn valuation, so there's at least that anecdote.
    - ryandamm 11y ago
RockyMcNuts 11y ago
A $1b valuation on a common stock is a different animal from a convertible preferred at a $1b valuation. The convertible preferred is almost closer to a bond with an attached warrant struck at a $1b valuation, with additional protections like non-dilution, IPO guarantees. Those terms make a big difference. Try to do a deal without them and see...will be a dealbreaker, or a vast change in multiple and other protections for the investor. If they didn't matter investors wouldn't demand them. https://www.fenwick.com/FenwickDocuments/The-Terms-Behind-The-Unicorn-Valuations.pdf https://www.fenwick.com/FenwickDocuments/The-Terms-Behind-Th... http://avc.com/2011/07/financing-options-preferred-stock/ http://avc.com/2011/07/financing-options-preferred-stock/
pbreit 11y ago
What are the terms that are relevant at IPO? Is it just that minimum price thing? It does seem like downside protection would be valuable but when you think how few of the unicorn will actually liquidate, you start to realize the valuations are real.

by grellas 11y ago

ClintEhrlich 11y ago

The article's analysis may have been superficial, but I don't understand why you dispute that liquidation-preference increases valuations. As you note, it offers investors protection against downside risk. That protection allows them to safely invest at higher valuations than they otherwise would, precisely because they will be protected if those valuations come plummeting down to earth. Without that guaranteed protection, they would need to demand lower valuations. The historical examples you offered are consistent with this theory. In the early 2000s, valuations would have been even lower without liquidation preference. And it's true that the huge upside of modern startups may account for their astronomical valuations, but investors are only willing to entertain such wild risks because of the protections they enjoy from downside risk. So, liquidation preference may not be a new phenomenon, but that doesn't mean it's not important.

philrapo 11y ago
To put it another way, downside protection / insurance has value.
pbreit 11y ago
But if that rarely/never happens, the protection probably isn't as valuable as many think. I'm guessing less than 10%. So Uber still gets a $46-49b valuation.

aliston 11y ago

It's unlikely that Dropbox, AirBnb etc. are going to liquidate, so I think you're right that liquidation preferences probably aren't as big a factor in the unicorn valuations. Most of the investors in the unicorns are late stage funds hoping for an IPO. However, it's not true that the preferred stock directly converts to common stock in all cases. My guess is that almost all of these deals involve ratchets, which are definitely driving up the implied valuations. It also means that if the valuation doesn't keep going up, common stock holders take a bath. Take Box's balance sheet pre-ipo as an example.

mrwilliamchang 11y ago

I have no first hand knowledge of this, so I'm probably wrong. Maybe it's more accurate to say that the late stage investments are driving valuations up (ie the a16z analysis). But a lot of these later stage investors would not have felt comfortable without the liquidation preferences. The key distinctions is that liquidation preferences are not critical a VC's decision to invest, but are critical to the later stage large institutional investor's decision.

philrapo 11y ago

Are you saying you'd value shares at the same amount with or without a liquidation preference? I'd value the shares with liquidation preference at a premium, no contest. e.g. 1,000 total shares. You can buy 10% (100 shares) for $10mm with 2x liquidation preference included. Now say I remove the liquidation preference. Your valuation model doesn't change? Mine certainly does. I'd value the shares lower, causing a lower company valuation for the 10% of the company that's changing hands. >The reason there are $1B+ valuations is primarily because the VCs believe the ventures will come to dominate major areas of commerce, will typically go public with sky-high valuations, and will continue to grow and dominate even after all that. Investing $100M at $1B valuation is risky but pays hugely if the company later becomes valued at $100B+. It pays hugely even in a down round with liquidation prefs. I'd invest $100mm at a $1bn valuation with 2x liquidation preference, even if I thought the monetization event would occur at a $300mm valuation (down -70%). I'd still get paid out $200mm for a +100% return. If I didnt have the liquidation preference, I would've lost -70%.

ryandamm 11y ago
I was under the impression that anything other than a 1x liquidation preference is extremely founder-unfavorable and very rare. Am I mistaken? Are these unicorns wandering around with significant (2x, 3x) preferences attached to them? Because otherwise, a 1x only says you get your principal back. Covers the VC's butt in a down round, but nothing crazy. To the extent it comes out of founders' hide, well, you took money and didn't manage to make it grow. (The effect on rank-and-file employee options is a little less defensible, though, since they have less control over total execution.)
- philrapo 11y ago
  I haven't seen any data on it, but that's my understanding as well. (>1x is rare in today's market). But the NYT article does mention Honest Co. with a 2x on $1.7bn valuation, so there's at least that anecdote.
  - ryandamm 11y ago

RockyMcNuts 11y ago

A $1b valuation on a common stock is a different animal from a convertible preferred at a $1b valuation. The convertible preferred is almost closer to a bond with an attached warrant struck at a $1b valuation, with additional protections like non-dilution, IPO guarantees. Those terms make a big difference. Try to do a deal without them and see...will be a dealbreaker, or a vast change in multiple and other protections for the investor. If they didn't matter investors wouldn't demand them. https://www.fenwick.com/FenwickDocuments/The-Terms-Behind-The-Unicorn-Valuations.pdf https://www.fenwick.com/FenwickDocuments/The-Terms-Behind-Th... http://avc.com/2011/07/financing-options-preferred-stock/ http://avc.com/2011/07/financing-options-preferred-stock/

pbreit 11y ago

What are the terms that are relevant at IPO? Is it just that minimum price thing? It does seem like downside protection would be valuable but when you think how few of the unicorn will actually liquidate, you start to realize the valuations are real.