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How to Build a Unicorn and Walk Away with Nothing

341 points by whbk 11y ago

krampian 11y ago
Of course terms matter, but the example she gives seems somewhat contrived. Particularly this part: >> In the deal, Hooli would invest $200 million for equity while in return the two companies would enter into a business development agreement on the side in which Pied Piper guarantees to spend that money in a massive consumer campaign on Hooli’s ad platform. They float the magic “B” valuation. Richard goes to sleep dreaming of rainbows and unicorns. If you take all that money in with a massive string like that attached (basically no freedom at all to spend it except on one thing), I would think you have only yourself to blame for the result.
- jforman 11y ago
  Sounds like this is roughly based on the Microsoft/Facebook deal. MSFT invested $240M at $15B valuation but won the right to be the ad platform for FB globally for some period of time. Not the same as forcing the investee into ad spend, but that's what it conjured up in my mind when I read it.
- enjo 11y ago
  That's the whole point of the article tho isn't? Terms matter. Terms similar to those do exist btw. Investors who aren't going to be able to wrangle board control often attempt to control their money using absurd up-front strategic requirements. You are correct. Taking that money is a massive mistake, but founders often do it to protect from bottom-line dilution. After all you can often negotiate a better valuation by taking worse terms on the deal. I've seen it up close and personal, the cautionary tale in the post is a good one. Valuation is important, but you really have to understand the terms you're entering into. A mentor described it to me as "always be steering for an optimal outcome for partial success". In other words if I'm valued at $10M today, then I want to make sure I'm going to do OK if we end up selling for $20M, as opposed to getting the best possible outcome at $100M. Ya I might leave a bunch of money on the table in the end, but in the ~$100M case I'm going to be really happy no matter what.
- chetanahuja 11y ago
  "If you take all that money in with a massive string like that attached.." Not to mention, this happens when you already have outside board members from your previous round of investment. So it's not just one dumb CEO making the deal, it's aided and abetted by (presumably wiser and cannier) prior investors. Yeah... that part rang the most untrue in that whole scenario. Take that out, and the rest of the story is basically a parable explaining what liquidation preferences mean. Is there any VC that would do a deal without 1x liquidation pref?
  - notahacker 11y ago
    In fairness, the newish VC needing an apparent success to help raise their next fund back back-story sounds like a worryingly plausible reason for them to be able to overlook the fact that Hoopli should never have been allowed liquidation preferences in addition to a contract guaranteeing they got their funds back through platform spend. I'd love to know how often this kind of 'instead of giving you free inventory, how about we "invest" conditional on you "buying" from us' shell game actually happens in the Valley though.
    - brudgers 11y ago
      I am not saying that it's happening or has happened or will happen, but Google, Facebook, Yahoo, etc. would certainly be the sort of investors who are in position to benefit from such an arrangement.
- wpietri 11y ago
  In retrospect, it's always easy to construct reasons why person X has only themselves to blame. Blame isn't really a useful construct for systemic improvement, because it always lets us say, "Oh, well this won't happen to me." The vast majority of Silicon Valley's failures were made by very smart people while being guided by very smart and experienced investors. "How could somebody be that dumb" is Silicon Valley's equivalent of "pilot error", a response that explains nothing because it can explain anything.
- mikekchar 11y ago
  Here is an interesting real world example that I think not many people know the details about. I don't think any of this information is privileged information. Most of this comes from my (probably faulty) memory with conversations I had with some of Corel's upper management (where I worked). Some of it comes from the public record. There are probably errors since it has been a long time and I didn't not double check the information. It is entirely possible that I was misled right from the beginning anyway, so it might just be fiction. But even if it is, it is entertaining fiction. In 2000 Microst invested £135 million in Corel. At the time Corel was almost out of cash (if my memory serves they had about $2 million in the bank and with about 1500 employees was going to run into a problem with payroll sooner rather than later). Corel issued new stock to cover the deal and I think it represented about 25% of total equity. This stock was non-voting, but came with a veto over new acquisitions. The rationale was that since Microsoft and Corel were playing in the same office productivity software market, Corel didn't want them to be able to dictate what they were doing, but at the same time Microsoft wanted to protect their investment against acquisitions that they thought were poor judgement. At that time, growing your business through acquisitions was all the rage and the Corel management team (led by it's relatively inexperienced CEO at the time) was quite keen to use some of the new capital to grow their business. Microsoft encouraged them and even brokered meetings, etc, etc. In the end Corel set up several acquisitions, which of course took some time to go through all the approval processes. In around 2003 Microsoft sold their Corel stock to the venture capital firm Vector for about £13 million (10% of their original investment). It is possibly not a coincidence that this is a venture capital firm that Paul Allen was involved with, but who knows? According to what the then Corel CEO told me at the time, Vector then threatened to use their acquisition veto if the board did not agree to back a complete buyout by Vector. The problem was that the penalty clauses for backing out of the acquisitions would once again put Corel into a very difficult situation financially. Feeling like they had no choice in the matter, the board approved the buy out and recommended that the investors accept the deal. Vector bought up all the remaining stock for $133 million, using about $80 million of Corel's remaining cash to finance the deal. Very soon afterwards they laid off a very large number of employees (including me ;-) ) and concentrated on profitability. As far as I know, Vector have managed the company exceptionally well since then. I heard from trusted sources that Corel's CEO at the time gave up a multi-million dollar parachute to accept a job at Microsoft, so I suspected that there was never really any need to feel particularly sorry for him. But you can see that one seemingly innocuous condition from an investor who is saving your butt can lead to the most unimaginable outcomes.
cperciva 11y ago
Seems to me that the problem here is less one of investment terms and preferences, and more one of wasting $200M on an unsuccessful advertising campaign. If you agree to throw that much money at advertising without having any guarantee that the advertising will yield (enough) results, you deserve to walk away with nothing.
- jsonne 11y ago
  Unfortunately you can't guarantee results with advertising. However, you can mitigate some risks by taking an iterative approach and testing things before doing a large integrated campaign. You can save a lot of headache by running some targeted facebook ads to see if they resonate with your audience before buying up a bunch of tv or radio points.
  - funkyy 11y ago
    You can, it is just more expensive. You can launch CPA campaign for example. It gives you guaranteed to some extent results.
  - cperciva 11y ago
    Unfortunately you can't guarantee results with advertising. Right, which is why you should never commit 90%+ of your available cash to an advertising campaign, but should instead spend a smaller amount and wait to see if you get results before you spend more.
  - alexqgb 11y ago
    The point wasn't whether or not the $200m ad spend was well advised or well managed. It was included in this scenario as a stand-in for any number of ways that a company could burn through a lot of cash without achieving a sustainable, defensible product / market fit, let alone solid traction. If you're focusing on what the fictional company did with the money, as opposed to the very real terms under which it acquired the money, you may want to re-read the piece.
    - cperciva 11y ago
nphyte 11y ago
It's good to know that the she watched the episode. Has anyone in the valley gone through this or?
powera 11y ago
If you get $240 million in investments, and then sell the company for $250 million, I fail to see how it was successful (or "building a unicorn") at all.
- static_noise 11y ago
  You also take on another dozen millions in additional liability which you have to pay on top of the 240 million. It was very successful for "Hooli" who basically channelled back their 200 million after investment and got another 200 million after the sale.
  - rsp1984 11y ago
    In even simpler terms, the deal generated 200m in ad sales for "Hooli".
- biot 11y ago
  The $200M investment was at a $1B valuation, thus it was an origami unicorn. However, one could argue that until someone actually forks over $1B, all valuations (even those of publicly listed companies) are on paper only.
- rokhayakebe 11y ago
  Remember by the time you are taking $240M your valuation is either $750M or $1 billion (depending on the $250M being part of the valuation); all of which you have achieved with some $11M. That is a close to a 100x return. But even if you lost $750M/$500M in valuation before the deal and sold for $250M after raising $11M, that is still a 24x return.
hmate9 11y ago
An interesting exercise is to think about what would have happened if that $200 million spent on advertisement on Hooli campaign gave a positive ROI. Than Richard would be really happy right now. What Richard should have done, is before accepting that $200 million, spend some of his own money on Hooli's ad platform to see what it was like, what kind of return they're looking at. If its good, take the money. If not, walk away. But of course, it's very easy to make the right decision after already knowing the outcome...
- jcoffland 11y ago
  Would Hooli would wait calmly on the sidelines with their offer still on the table while you did so?
  - lmm 11y ago
    If they wouldn't, what does that tell you about them?
kens 11y ago
The article says that Richard would have personal liability if the sale didn't go through. That doesn't make sense to me - can someone explain? Edit: the article says both Richard and the investors would have personal liability, but isn't a purpose of a corporation to avoid personal liability?
- idlewords 11y ago
  I believe it says the investors could be liable.
- cperciva 11y ago
  Board members can theoretically face personal liability if they fail to discharge their fiduciary duty to act in the best interest of the shareholders. And in some states I think claims can also be made against directors for unpaid wages -- I'm not sure how the jurisdictional issues play out for a Delaware corporation with employees elsewhere though.
  - alexqgb 11y ago
    That was exactly the point - the personal liability isn't to the investors, it's to the state, which tends to take a very dim view of unpaid wages. In California, I believe treble damages are standard, so missing a $50,000 payroll can cost you $200,000 in addition to court fees and legal costs. INALB I'm pretty sure this is what the OP was getting at.
- deleted 11y ago
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walshemj 11y ago
Why would the CEO Richard be liable for the wages surely that is the company's liabilities not his personal one
- hglaser 11y ago
  Unpaid wages are one of the few ways to pierce the corporate veil. In the US, officers of the corporation can be personally liable for unpaid wages.
  - walshemj 11y ago
    seems to defeat the purpose of a PLC
    - chiph 11y ago
      The US states take unpaid employees very seriously. Think about it from the employee's point of view - if the company can't make payroll one week, you might be tempted to let it ride until next week. If they again can't make payroll, you've put 80+ (120+!) hours into the firm with no payment. I certainly wouldn't be happy in that situation.
      - _delirium 11y ago
        This also partly aligns with it being very easy to fire people in the US. The government therefore views the employer as having a perfectly reasonable option in the case where they are truly short of money: fire the employees you can't afford to pay before they work the hours you don't have money for (or something halfway, like giving people a non-optional offer to go down to half-time). In most cases that can even be done with no notice, though that isn't very nice. But it is at least seen as more honest than stringing people along ostensibly working for a salary they aren't going to get. In practice one way to handle this is keep one payroll cycle's worth of liquid cash "locked up" in an account that is reserved for payroll and which you don't dip into for other expenses. So even in the worst case the last paychecks can be sent out before shutting down, if you avoid the temptation to dip into that account "just this once". That does require having a little bit of a cash cushion, but a VC-funded company should be in a relatively good position in that regard.
idlewords 11y ago
I find this article much more interesting as a cultural snapshot than a cautionary tale for founders. $20 million in investment before creating a minimal product, $200 million to find out users won't pay for what you made, and everything propped up by a shell game around online ads. The assumption that the founder of this should have walked away with a fortune is just the cherry on top.
- nostrademons 11y ago
  I think that's part of the author's point: that valuations are, in a very important sense, largely fictitious, and that other actors in the ecosystem can make your valuation as large or as small as possible to suit their purposes. If you want to build a business, your actions need to actually do that, and you should be aware of and mitigate the implications of any wild valuation swings. Similarly, if you want to get rich (which may or may not be aligned with building a business), your actions should do that, and that also may or may not follow from getting a big valuation.
  - paulpauper 11y ago
    As lot of people are saying that, but the empirical evidence suggests that the valuations, as high as they are, are remarkably sticky. I can only name two web 2.0 duds, zynga and fab, but the rest of the unicorns have either held their value or keep rising. It's not like Uber or Snapchat will become the next friendster and myspace. The failure rate for the $40-90 million valuation range seems much higher than the >$1 billion.
    - lacker 11y ago
      Zynga is still worth $2.6B so I would not call them a "dud". http://finance.yahoo.com/q/ks?s=ZNGA+Key+Statistics http://finance.yahoo.com/q/ks?s=ZNGA+Key+Statistics
      - notahacker 11y ago
        They might not be staring death in the face, but you'd call it a dud if you'd bought it at the "unicorn" valuation of $11.5Bn. Given Zynga is losing money not trying to grow so much as reinvent themselves to keep up with their users' short attention spans, I'd be much happier being short on them than long too. Though FWIW, I think Zynga's performance is probably better than Snapchat will do long term, since they at least nailed the art of generating revenue.
jim_greco 11y ago
Talking your book much? This story is so contrived that it hinges on a comically inept founder taking $200M to solely spend on an advertising campaign on the platform of the person investing it. If this is the best example a VC can offer to cram down valuations then I'm pretty sure founders are going to keep reaching toward those unicorn valuations.
- paulpauper 11y ago
  Seems everyone wants their 'I told you so' moment. Why can't we just accept that web 2.0 and these high valuations aren't going away?
- x0x0 11y ago
  ever heard of living social? How much of amazon's investment was recycled into purchases (obviously with lower margins than ads) on amazon when they offered a $20 amazon gift card for $10?
rsp1984 11y ago
All the right things have been said in other comments already, however I'd like to point out that the outcome for Peter, the angel investor is a little unclear from the article. It says: > Peter, while sad about the outcome, has developed a huge syndication following on AngelList and has recently benefitted from an early acquisition that netted him $3 million on a $250k investment. Can’t win them all, but he’s at peace. Assuming the investment was in convertible notes, surely the debt would have converted into shares at the same terms that the VC investment happened, including the liquidation preference. So if the VC gets to take chips off the table so would Peter, I assume?
jcoffland 11y ago
Great to see a VC being honest about the business. Richard should have never agreeded to the $200m deal with ad spending strings but I'm sure deals like this happen all the time. The pressure on an entrepreneur in such situations must be immense. I imagine others with much more experience giving advice but with their own motivations in mind. I could easily see founders such as Richard making decisions in the moment which are obviously bad looking back.
dataker 11y ago
Makes me wonder if building a company still is financially wise. Even if you're successful, a prominent well-established career path will probably balance out an average startup exit(assuming there's one).
- chrisper 11y ago
  I guess people are hoping for the rare occasion where you will be either bought up or you can go IPO one day.
- mellavora 11y ago
  Was it ever financially wise?
  - mellavora 11y ago
    I'm not saying not to do it, just saying that there are easier ways to get wealth. You might be in the game for other reasons.
  - Alleluja 11y ago
    The point is there are other ways "to make it" except for VC founded c-corp and stable employment. Huge majority of successful businesses in the US (and business owners) make it without VCs and their money. I know of a guy who made millions by developing a sms-sending platform. No debt. No outside investment. That's the way really smart guys do it. Guys in the same category will take VC money because they know they own facebook or google. The rest are , well... dreamers...
- adventured 11y ago
  99% of all corporations in the US are private. They operate day to day without intent to ever do an IPO or get purchased. The alternative answer is: people build a business with actual cash flow and profits that can sustain itself and grow under normal conditions without the need for vast sums of venture capital. Nearly all of the $18 trillion US economy operates outside the economic sphere this article is talking about.
sharemywin 11y ago
Not sure the last deal would have even been up to the CEO. a deal like that would probably be a board vote, I would think and you may only have 40% of the vote. also, what if it was the only deal on the table and the trial campaign preformed well. Btw, Forbes called they heard about the deal and your going to be on the cover. And let's talk about poor Richard I don't he's managing an Arby's after he ran a billion dolllar company. Probably some kind of senior executive somewhere. Curious if VC would take his calls?
myth_buster 11y ago
I was wondering whether the build a waterfall spreadsheet could be opensourced by this community given that there are lot people here with varied experiences. PS: I found this blog quite informative and the meta meta ref amuses me.
- andor436 11y ago
  This isn't bad: https://smartasset.com/infographic/startup https://smartasset.com/infographic/startup Although it's not as clear as a spreadsheet would be, I think it's easier to start with.
  - sparkzilla 11y ago
    Thank you for the link. Very informative.
    - myth_buster 11y ago
      I second that. I found other interesting information on the site. Thanks for sharing.
brianmcconnell 11y ago
There's another way to skin this cat. Assume you are not "CEO material", hire someone who turns out to be a complete fuckup to do it for you because of your self doubt. I saw this happen to a company that basically invented the concept of hosted phone/communication services for business, back in the mid 90s. Their competitors are worth billions now. The third rate/bully/crook CEO the founder hired destroyed, literally, billions in opportunity. (In retrospect the whole company was rotten to the core, so I enjoyed watching their competitor ring the NYSE bell, but if the founder had taken on the task of understanding his own business, this outcome would probably have been avoided).
- InternetUser 11y ago
  Can you at least give a hint as to who either company is?
simi_ 11y ago
And yet nobody sees a problem in creating stupid crap for stupid users and expecting to ~break even~ get rich selling ads. This reminds me of a recent article [0], where this line stood out: > “We just introduced an emoji feature and comments are there so you can have conversations, and there’s more stuff in collaborative streaming that we’re going to introduce,” he added. "We found a new niche and Twitter is trying to bully us out of it, but look, we'll have emoji soon. Comments too, and more social stuff. It's going to be great!" Sorry to cherry-pick Meerkat, they're actually an OK bunch, but that quote just stuck with me. Add to this silliness how much money/interest is garnered by apps like Instagram, Snapchat, WhatsApp (actually, arguably solving a real problem), and it's hard to argue we're not in a similarly idiotic bubble to the previous one. Of course, this also creates valuable stuff (my favourite recently being Slack), but I'd be willing to bet that this huge BS-to-usefulness ratio isn't sustainable in the long term. 0: http://techcrunch.com/2015/05/06/meerkat-founder-on-getting-the-kill-call-from-twitter/ http://techcrunch.com/2015/05/06/meerkat-founder-on-getting-... edit: instant downvote - if you don't just disagree with my tone, please explain why you think I'm wrong edit 2: I'm not saying I have an answer, but at least I tried to pick something that seemed worth doing (I work at Lavaboom, we're trying to make encrypted email easy to use - with extra privacy sprinkled on top)
- PavleMiha 11y ago
  I think the issue people have with your comment is that you seem to label things you don't use as stupid crap for stupid users. Snapchat, Instagram and WhatsApp solve a very real problem and are very useful for the hundreds of millions of people that use these services multiple times a day. It seems that you only label stuff as valuable if it solves problems you have (Slack and Lavaboom). I'm not a daily Instagram user, but some of my friends love it. They're not dumb, they just get more enjoyment out looking at and sharing pictures of cool shit and their friends.
  - deleted 11y ago
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  - AndrewKemendo 11y ago
    It seems that you only label stuff as valuable if it solves problems you have The idea that things that are popular are "solving a problem" is a really bad trend in my opinion. "A problem" is something that has generally identifiable boundaries and detrimental implications if not solved - for example not being able to send someone money is a problem, and one big enough that it warranted the creation of paypal and the like. I doubt highly that the millions of snapchat users at some point said "If only there were a service that deleted my pictures 10 seconds after I took them." The major differentiation in my mind between a service that "solves a problem" and another "bullshit service" is whether people are willing to pay for it. That's not to say you can't get rich off of bullshit, the E! network among others is proof of that, but lets not fool ourselves into thinking these things actually make the world better.
methodover 11y ago
Hm. As an engineer relatively new to the world of entrepreneurship, I find myself not really understanding much of the jargon. (Actually, I think I might understand some - but my confidence in my understanding is low.) It would be cool if there was like, an annotated version of this explaining some of the accounting/investing jargon. For example, this passage: Richard attracts Peter, a newly-wealthy budding angel investor, who agrees to put in $1 million as a note with a $5 million cap and a 20% discount. I think this means that Peter is buying part of Richard's company for 1 million bucks. He's valuing it at 5 million, so that's 20% of the company. However, there's a discount of 20%... Which is where I get confused. Does this mean that Peter is paying only 800,000, but getting 20%? Probably not, given the context. It probably means he gets 24% of the company, right? (He's getting 1.2M worth of shares for the cost of 1M.)
- sokoloff 11y ago
  You mostly have it. The $5MM is a cap, not a price. If the Series A is raised at $5MM or more valuation, then the angel gets his money ($1MM) converted at $4MM ($5MM * 0.8). If the Series A goes at $4MM, the angel's money is converted at a $3.2MM valuation (4*0.8)
  - carrotleads 11y ago
    The 20% discount confused me too. Am I right then that the discount is to calculate the equity % based on a future Series A valuation. if so in the scenrio's you posted above what is the new Equity % for the angel. Looks like it is 20% once it crosses $5m cap as inferred in the article.
    - sokoloff 11y ago
      You forced me to look it up (thank you for that). It seems like either the cap xor the discount applies (investors' option), so anything over $6.25MM valuation, the cap would apply and anything under that the discount would apply. It's too late for me to edit the GP post, so I'll try to correct it here: At a $5MM priced round, the discount would apply and the investor's note would convert $1MM at a $4MM valuation (25%). I believe that conversion is done pre-money, which means the angel is diluted (like all shareholders) from their initial 25% by the addition of the new money. (None of my angel investments have [yet] raised a priced round, so I haven't gone through this process, though I obviously hope to... :) ) If someone else invests $1MM at $5MM pre-money valuation, all prior investors are diluted by 16.6667%. (Someone who held 10% of $5MM pre-money company will hold 8.333% of a $6MM company post-money. Either way, their position is worth $500K.) So, to know the angel's ownership in the scenario, you need to know how much dilution happened due to the new money, meaning you need to know not just the pre-money valuation, but also the amount of new investment money. In any scenario where the discount applies, the angel's position will be worth $1MM. In any scenario where the cap is better than the discount, the angel's position will be worth more than $1MM.
AndrewKemendo 11y ago
So what is the reasonable repeatable way to determine or gauge valuation? From what we have seen it is "Investor A wants X% of B and is willing to pay Z for it" therefore value is the multiple of Z that equals 100%. AkA Whatever someone will pay for it, AkA market prices. Except it's rarely a market in the traditional sense as it's really ever only a handful of buyers and they value it based on god knows what metrics. Seems flimsy and based on whatever the most recent investor thinks - due diligence best practices aside. We need a standard way to determine valuation so that founders and investors alike can point to something that is based in reality and can't be gamed as easily.
- netcan 11y ago
  Demanding a standard way to determine valuation is in some ways like demanding a standard way of coming up with ideas. The reason prices are determined this subjectively is because information is incomplete. That means you need to use a lot more one off judgements that can't be fit into a standard. If information was better then there would already be useful standards. There are pretty decent standards for companies that demonstrate a lot of consistency, like shipping companies. There are ways for valuing stock. On the other end of the spectrum, valuing a company that is still a work in progress is a different kind of problem. The upside is bigger and the downside more likely.
  - AndrewKemendo 11y ago
    The reason prices are determined this subjectively is because information is incomplete. That is every market ever. No entity makes decisions based on perfect information - but plenty have a process that is auditable and lays out the assumptions. If information was better then there would already be useful standards. I think whatever standard or process we did come up with would be more refined/accurate with more information - but I that doesn't preclude having something that can be audited. I'm not saying that the process would spit out the "right" valuation, because that is impossible to tell prior to a liquidation event. What I am saying is that the process for determining valuations needs to be 100% more transparent. Like it or not there is a process - maybe it's all in one principle's head, but it's there. We as founders need to know what that is.
hackaflocka 11y ago
Great article. Would love a simple, colloquial explanation of the following phrases: * $1 million as a note with a $5 million cap and a 20% discount. * senior liquidity preference of 1x to protect their downside since they feel the valuation is rich * Peter, is stoked that he is getting his $1 million investment converted into roughly 20% * senior 1x liquidation preference * the preference overhang of $211 million * They ask prior investors to recap * the ‘overhang math’. * senior preference and a 2x guarantee. * waterfall spreadsheet
- nirmel 11y ago
  > $1 million as a note with a $5 million cap and a 20% discount. This refers to an investment done on a "convertible note." These particular terms mean that the valuation at which their investment will "convert" from what is nominally a loan into equity will be at most $5m, but if a subsequent investor invests in an equity financing at less than 6.25m, their investment will convert to equity at 20% less than the valuation. Read up on convertible notes for more detail. > senior liquidity preference of 1x to protect their downside since they feel the valuation is rich Means that in a sale, the investor will get the full amount (1x) of what they invested before others (i.e. founders, employees) see anything. > Peter, is stoked that he is getting his $1 million investment converted into roughly 20% Since the valuation was > 6.25m his valuation was capped at $5m, whereas the investors who are investing got a valuation of $40m "pre-money" or $50m "post-money" which are much less favorable terms than what Peter invested at. > the preference overhang of $211 million Means that if the company is to be acquired, it would take an acquisition offer of at least $211 million for founders and employees to see even a penny. That is because that amount was invested with the "1x" preference. > They ask prior investors to recap I think this means they are asking previous investors to lower the amount of liquidity preference they have such that in the event of a sale under $211m the founders would see some return. > the ‘overhang math’. The wiser employees understand the math that says an acquisition has to be enormous for them to see anything. If they don't think that's likely they will see little motivation to continue working at the company. > senior preference and a 2x guarantee. 2x guarantee means that they would be guaranteed twice the amount the invested in the event of a sale, possibly ahead of other investors, but I'm not sure. > waterfall spreadsheet Indicates how much each interested party would get in proceeds in the event of exits of various amounts. E.g. if company sells for X, investors get Y and founders get nothing. If company sells for Z, investors get X1 and founder gets Z. Etc.
api 11y ago
It seems obvious to me that giant valuation means insanely high bar before you see upside. I am a bit skeptical of the idea that it should be as high as possible, since if it's fundamentally ridiculous and there's no way you will ever live up to it I fail to see how this is in anyone's interest.
bshanks 11y ago
Hypothetically, assume a company whose valuation increases roughly geometrically at first, but then levels off at an asymptote, and assume that during the geometric phase the valuation fluctuates by 50% around its trend. Assume that no one knows where the asymptote is. Periodically, there are funding events, during which the company sells stock at a 1x liquidation preference; assume it sells enough stock so that at each funding event, the sum of the liquidation preferences is greater than 50% of its valuation. Consider a funding event that occurs when the valuation happens to be 25% above trend; therefore the liquidation preferences will be greater than 0.625 of the on-trend valuation, and then the next time that the valuation falls to 50% below trend, the sum of those preferences will be greater than the company's current valuation. At this point, many of those with liquidation preferences (some of whom may have a short time horizon; or may be risk-averse; or may believe that the current valuation will not rise very much in the future) may strongly prefer selling or liquidating the company immediately, which is at odds with common-stock-holders, who would get nothing in such a liquidation and who would prefer to keep going. Note that in this model, this result occurred not because of mismanagement, but due to the natural and expected fluctuation in market prices, combined with unavoidable uncertainty about which price changes are fluctuations and which are simply 'the new normal', combined with the sum of liquidation preferences being comparable in magnitude to the fluctuations in prices, combined with the bad luck of a funding event happening to occur when the valuation was above trend. Is this model reasonable? If so, how should management of such a company approach fundraising? It seems to me that fluctuations are inevitable and that the only thing management could control is how much money they raise at once; if fluctuations are 50% around trend, then management needs to keep the amount of money raised small enough so as to keep the sum of liqudiation preferences well under 1/3 of the current valuation (because in that case even if the valuation falls from 50% over trend to 50% under trend, the valuation will still be strictly greater than the sum of liquidation preferences). More realistically, the size of fluctuations would not be known in advance to be 50% but must be estimated. In the article, the valuation fluctuated from $1bil to $250mil, so the fluctuation parameter would be at least (1-x)/(1+x) = 250/1000 = 4 -> x = 3/5 = 60%, and the sum of liquidation prefs "should have" been kept well less than 250/1000 = 1/4 of the current valuation.
DonGateley 11y ago
Is there a good text which would make the meaning of all this clear?

341 points by whbk 11y ago

Of course terms matter, but the example she gives seems somewhat contrived. Particularly this part: >> In the deal, Hooli would invest $200 million for equity while in return the two companies would enter into a business development agreement on the side in which Pied Piper guarantees to spend that money in a massive consumer campaign on Hooli’s ad platform. They float the magic “B” valuation. Richard goes to sleep dreaming of rainbows and unicorns. If you take all that money in with a massive string like that attached (basically no freedom at all to spend it except on one thing), I would think you have only yourself to blame for the result.

jforman 11y ago
Sounds like this is roughly based on the Microsoft/Facebook deal. MSFT invested $240M at $15B valuation but won the right to be the ad platform for FB globally for some period of time. Not the same as forcing the investee into ad spend, but that's what it conjured up in my mind when I read it.
enjo 11y ago
That's the whole point of the article tho isn't? Terms matter. Terms similar to those do exist btw. Investors who aren't going to be able to wrangle board control often attempt to control their money using absurd up-front strategic requirements. You are correct. Taking that money is a massive mistake, but founders often do it to protect from bottom-line dilution. After all you can often negotiate a better valuation by taking worse terms on the deal. I've seen it up close and personal, the cautionary tale in the post is a good one. Valuation is important, but you really have to understand the terms you're entering into. A mentor described it to me as "always be steering for an optimal outcome for partial success". In other words if I'm valued at $10M today, then I want to make sure I'm going to do OK if we end up selling for $20M, as opposed to getting the best possible outcome at $100M. Ya I might leave a bunch of money on the table in the end, but in the ~$100M case I'm going to be really happy no matter what.
chetanahuja 11y ago
"If you take all that money in with a massive string like that attached.." Not to mention, this happens when you already have outside board members from your previous round of investment. So it's not just one dumb CEO making the deal, it's aided and abetted by (presumably wiser and cannier) prior investors. Yeah... that part rang the most untrue in that whole scenario. Take that out, and the rest of the story is basically a parable explaining what liquidation preferences mean. Is there any VC that would do a deal without 1x liquidation pref?
- notahacker 11y ago
  In fairness, the newish VC needing an apparent success to help raise their next fund back back-story sounds like a worryingly plausible reason for them to be able to overlook the fact that Hoopli should never have been allowed liquidation preferences in addition to a contract guaranteeing they got their funds back through platform spend. I'd love to know how often this kind of 'instead of giving you free inventory, how about we "invest" conditional on you "buying" from us' shell game actually happens in the Valley though.
  - brudgers 11y ago
    I am not saying that it's happening or has happened or will happen, but Google, Facebook, Yahoo, etc. would certainly be the sort of investors who are in position to benefit from such an arrangement.
wpietri 11y ago
In retrospect, it's always easy to construct reasons why person X has only themselves to blame. Blame isn't really a useful construct for systemic improvement, because it always lets us say, "Oh, well this won't happen to me." The vast majority of Silicon Valley's failures were made by very smart people while being guided by very smart and experienced investors. "How could somebody be that dumb" is Silicon Valley's equivalent of "pilot error", a response that explains nothing because it can explain anything.
mikekchar 11y ago
Here is an interesting real world example that I think not many people know the details about. I don't think any of this information is privileged information. Most of this comes from my (probably faulty) memory with conversations I had with some of Corel's upper management (where I worked). Some of it comes from the public record. There are probably errors since it has been a long time and I didn't not double check the information. It is entirely possible that I was misled right from the beginning anyway, so it might just be fiction. But even if it is, it is entertaining fiction. In 2000 Microst invested £135 million in Corel. At the time Corel was almost out of cash (if my memory serves they had about $2 million in the bank and with about 1500 employees was going to run into a problem with payroll sooner rather than later). Corel issued new stock to cover the deal and I think it represented about 25% of total equity. This stock was non-voting, but came with a veto over new acquisitions. The rationale was that since Microsoft and Corel were playing in the same office productivity software market, Corel didn't want them to be able to dictate what they were doing, but at the same time Microsoft wanted to protect their investment against acquisitions that they thought were poor judgement. At that time, growing your business through acquisitions was all the rage and the Corel management team (led by it's relatively inexperienced CEO at the time) was quite keen to use some of the new capital to grow their business. Microsoft encouraged them and even brokered meetings, etc, etc. In the end Corel set up several acquisitions, which of course took some time to go through all the approval processes. In around 2003 Microsoft sold their Corel stock to the venture capital firm Vector for about £13 million (10% of their original investment). It is possibly not a coincidence that this is a venture capital firm that Paul Allen was involved with, but who knows? According to what the then Corel CEO told me at the time, Vector then threatened to use their acquisition veto if the board did not agree to back a complete buyout by Vector. The problem was that the penalty clauses for backing out of the acquisitions would once again put Corel into a very difficult situation financially. Feeling like they had no choice in the matter, the board approved the buy out and recommended that the investors accept the deal. Vector bought up all the remaining stock for $133 million, using about $80 million of Corel's remaining cash to finance the deal. Very soon afterwards they laid off a very large number of employees (including me ;-) ) and concentrated on profitability. As far as I know, Vector have managed the company exceptionally well since then. I heard from trusted sources that Corel's CEO at the time gave up a multi-million dollar parachute to accept a job at Microsoft, so I suspected that there was never really any need to feel particularly sorry for him. But you can see that one seemingly innocuous condition from an investor who is saving your butt can lead to the most unimaginable outcomes.

cperciva 11y ago

Seems to me that the problem here is less one of investment terms and preferences, and more one of wasting $200M on an unsuccessful advertising campaign. If you agree to throw that much money at advertising without having any guarantee that the advertising will yield (enough) results, you deserve to walk away with nothing.

jsonne 11y ago
Unfortunately you can't guarantee results with advertising. However, you can mitigate some risks by taking an iterative approach and testing things before doing a large integrated campaign. You can save a lot of headache by running some targeted facebook ads to see if they resonate with your audience before buying up a bunch of tv or radio points.
- funkyy 11y ago
  You can, it is just more expensive. You can launch CPA campaign for example. It gives you guaranteed to some extent results.
- cperciva 11y ago
  Unfortunately you can't guarantee results with advertising. Right, which is why you should never commit 90%+ of your available cash to an advertising campaign, but should instead spend a smaller amount and wait to see if you get results before you spend more.
- alexqgb 11y ago
  The point wasn't whether or not the $200m ad spend was well advised or well managed. It was included in this scenario as a stand-in for any number of ways that a company could burn through a lot of cash without achieving a sustainable, defensible product / market fit, let alone solid traction. If you're focusing on what the fictional company did with the money, as opposed to the very real terms under which it acquired the money, you may want to re-read the piece.
  - cperciva 11y ago

nphyte 11y ago

It's good to know that the she watched the episode. Has anyone in the valley gone through this or?

powera 11y ago

If you get $240 million in investments, and then sell the company for $250 million, I fail to see how it was successful (or "building a unicorn") at all.

static_noise 11y ago
You also take on another dozen millions in additional liability which you have to pay on top of the 240 million. It was very successful for "Hooli" who basically channelled back their 200 million after investment and got another 200 million after the sale.
- rsp1984 11y ago
  In even simpler terms, the deal generated 200m in ad sales for "Hooli".
biot 11y ago
The $200M investment was at a $1B valuation, thus it was an origami unicorn. However, one could argue that until someone actually forks over $1B, all valuations (even those of publicly listed companies) are on paper only.
rokhayakebe 11y ago
Remember by the time you are taking $240M your valuation is either $750M or $1 billion (depending on the $250M being part of the valuation); all of which you have achieved with some $11M. That is a close to a 100x return. But even if you lost $750M/$500M in valuation before the deal and sold for $250M after raising $11M, that is still a 24x return.

hmate9 11y ago

An interesting exercise is to think about what would have happened if that $200 million spent on advertisement on Hooli campaign gave a positive ROI. Than Richard would be really happy right now. What Richard should have done, is before accepting that $200 million, spend some of his own money on Hooli's ad platform to see what it was like, what kind of return they're looking at. If its good, take the money. If not, walk away. But of course, it's very easy to make the right decision after already knowing the outcome...

jcoffland 11y ago
Would Hooli would wait calmly on the sidelines with their offer still on the table while you did so?
- lmm 11y ago
  If they wouldn't, what does that tell you about them?

kens 11y ago

The article says that Richard would have personal liability if the sale didn't go through. That doesn't make sense to me - can someone explain? Edit: the article says both Richard and the investors would have personal liability, but isn't a purpose of a corporation to avoid personal liability?

idlewords 11y ago
I believe it says the investors could be liable.
cperciva 11y ago
Board members can theoretically face personal liability if they fail to discharge their fiduciary duty to act in the best interest of the shareholders. And in some states I think claims can also be made against directors for unpaid wages -- I'm not sure how the jurisdictional issues play out for a Delaware corporation with employees elsewhere though.
- alexqgb 11y ago
  That was exactly the point - the personal liability isn't to the investors, it's to the state, which tends to take a very dim view of unpaid wages. In California, I believe treble damages are standard, so missing a $50,000 payroll can cost you $200,000 in addition to court fees and legal costs. INALB I'm pretty sure this is what the OP was getting at.
deleted 11y ago
[deleted]

walshemj 11y ago

Why would the CEO Richard be liable for the wages surely that is the company's liabilities not his personal one

hglaser 11y ago
Unpaid wages are one of the few ways to pierce the corporate veil. In the US, officers of the corporation can be personally liable for unpaid wages.
- walshemj 11y ago
  seems to defeat the purpose of a PLC
  - chiph 11y ago
    The US states take unpaid employees very seriously. Think about it from the employee's point of view - if the company can't make payroll one week, you might be tempted to let it ride until next week. If they again can't make payroll, you've put 80+ (120+!) hours into the firm with no payment. I certainly wouldn't be happy in that situation.
    - _delirium 11y ago
      This also partly aligns with it being very easy to fire people in the US. The government therefore views the employer as having a perfectly reasonable option in the case where they are truly short of money: fire the employees you can't afford to pay before they work the hours you don't have money for (or something halfway, like giving people a non-optional offer to go down to half-time). In most cases that can even be done with no notice, though that isn't very nice. But it is at least seen as more honest than stringing people along ostensibly working for a salary they aren't going to get. In practice one way to handle this is keep one payroll cycle's worth of liquid cash "locked up" in an account that is reserved for payroll and which you don't dip into for other expenses. So even in the worst case the last paychecks can be sent out before shutting down, if you avoid the temptation to dip into that account "just this once". That does require having a little bit of a cash cushion, but a VC-funded company should be in a relatively good position in that regard.

idlewords 11y ago

I find this article much more interesting as a cultural snapshot than a cautionary tale for founders. $20 million in investment before creating a minimal product, $200 million to find out users won't pay for what you made, and everything propped up by a shell game around online ads. The assumption that the founder of this should have walked away with a fortune is just the cherry on top.

nostrademons 11y ago
I think that's part of the author's point: that valuations are, in a very important sense, largely fictitious, and that other actors in the ecosystem can make your valuation as large or as small as possible to suit their purposes. If you want to build a business, your actions need to actually do that, and you should be aware of and mitigate the implications of any wild valuation swings. Similarly, if you want to get rich (which may or may not be aligned with building a business), your actions should do that, and that also may or may not follow from getting a big valuation.
- paulpauper 11y ago
  As lot of people are saying that, but the empirical evidence suggests that the valuations, as high as they are, are remarkably sticky. I can only name two web 2.0 duds, zynga and fab, but the rest of the unicorns have either held their value or keep rising. It's not like Uber or Snapchat will become the next friendster and myspace. The failure rate for the $40-90 million valuation range seems much higher than the >$1 billion.
  - lacker 11y ago
    Zynga is still worth $2.6B so I would not call them a "dud". http://finance.yahoo.com/q/ks?s=ZNGA+Key+Statistics http://finance.yahoo.com/q/ks?s=ZNGA+Key+Statistics
    - notahacker 11y ago
      They might not be staring death in the face, but you'd call it a dud if you'd bought it at the "unicorn" valuation of $11.5Bn. Given Zynga is losing money not trying to grow so much as reinvent themselves to keep up with their users' short attention spans, I'd be much happier being short on them than long too. Though FWIW, I think Zynga's performance is probably better than Snapchat will do long term, since they at least nailed the art of generating revenue.

jim_greco 11y ago

Talking your book much? This story is so contrived that it hinges on a comically inept founder taking $200M to solely spend on an advertising campaign on the platform of the person investing it. If this is the best example a VC can offer to cram down valuations then I'm pretty sure founders are going to keep reaching toward those unicorn valuations.

paulpauper 11y ago
Seems everyone wants their 'I told you so' moment. Why can't we just accept that web 2.0 and these high valuations aren't going away?
x0x0 11y ago
ever heard of living social? How much of amazon's investment was recycled into purchases (obviously with lower margins than ads) on amazon when they offered a $20 amazon gift card for $10?

rsp1984 11y ago

All the right things have been said in other comments already, however I'd like to point out that the outcome for Peter, the angel investor is a little unclear from the article. It says: > Peter, while sad about the outcome, has developed a huge syndication following on AngelList and has recently benefitted from an early acquisition that netted him $3 million on a $250k investment. Can’t win them all, but he’s at peace. Assuming the investment was in convertible notes, surely the debt would have converted into shares at the same terms that the VC investment happened, including the liquidation preference. So if the VC gets to take chips off the table so would Peter, I assume?

jcoffland 11y ago

Great to see a VC being honest about the business. Richard should have never agreeded to the $200m deal with ad spending strings but I'm sure deals like this happen all the time. The pressure on an entrepreneur in such situations must be immense. I imagine others with much more experience giving advice but with their own motivations in mind. I could easily see founders such as Richard making decisions in the moment which are obviously bad looking back.

dataker 11y ago

Makes me wonder if building a company still is financially wise. Even if you're successful, a prominent well-established career path will probably balance out an average startup exit(assuming there's one).

chrisper 11y ago
I guess people are hoping for the rare occasion where you will be either bought up or you can go IPO one day.
mellavora 11y ago
Was it ever financially wise?
- mellavora 11y ago
  I'm not saying not to do it, just saying that there are easier ways to get wealth. You might be in the game for other reasons.
- Alleluja 11y ago
  The point is there are other ways "to make it" except for VC founded c-corp and stable employment. Huge majority of successful businesses in the US (and business owners) make it without VCs and their money. I know of a guy who made millions by developing a sms-sending platform. No debt. No outside investment. That's the way really smart guys do it. Guys in the same category will take VC money because they know they own facebook or google. The rest are , well... dreamers...
adventured 11y ago
99% of all corporations in the US are private. They operate day to day without intent to ever do an IPO or get purchased. The alternative answer is: people build a business with actual cash flow and profits that can sustain itself and grow under normal conditions without the need for vast sums of venture capital. Nearly all of the $18 trillion US economy operates outside the economic sphere this article is talking about.

sharemywin 11y ago

Not sure the last deal would have even been up to the CEO. a deal like that would probably be a board vote, I would think and you may only have 40% of the vote. also, what if it was the only deal on the table and the trial campaign preformed well. Btw, Forbes called they heard about the deal and your going to be on the cover. And let's talk about poor Richard I don't he's managing an Arby's after he ran a billion dolllar company. Probably some kind of senior executive somewhere. Curious if VC would take his calls?

myth_buster 11y ago

I was wondering whether the build a waterfall spreadsheet could be opensourced by this community given that there are lot people here with varied experiences. PS: I found this blog quite informative and the meta meta ref amuses me.

andor436 11y ago
This isn't bad: https://smartasset.com/infographic/startup https://smartasset.com/infographic/startup Although it's not as clear as a spreadsheet would be, I think it's easier to start with.
- sparkzilla 11y ago
  Thank you for the link. Very informative.
  - myth_buster 11y ago
    I second that. I found other interesting information on the site. Thanks for sharing.

brianmcconnell 11y ago

There's another way to skin this cat. Assume you are not "CEO material", hire someone who turns out to be a complete fuckup to do it for you because of your self doubt. I saw this happen to a company that basically invented the concept of hosted phone/communication services for business, back in the mid 90s. Their competitors are worth billions now. The third rate/bully/crook CEO the founder hired destroyed, literally, billions in opportunity. (In retrospect the whole company was rotten to the core, so I enjoyed watching their competitor ring the NYSE bell, but if the founder had taken on the task of understanding his own business, this outcome would probably have been avoided).

InternetUser 11y ago
Can you at least give a hint as to who either company is?

simi_ 11y ago

And yet nobody sees a problem in creating stupid crap for stupid users and expecting to ~break even~ get rich selling ads. This reminds me of a recent article [0], where this line stood out: > “We just introduced an emoji feature and comments are there so you can have conversations, and there’s more stuff in collaborative streaming that we’re going to introduce,” he added. "We found a new niche and Twitter is trying to bully us out of it, but look, we'll have emoji soon. Comments too, and more social stuff. It's going to be great!" Sorry to cherry-pick Meerkat, they're actually an OK bunch, but that quote just stuck with me. Add to this silliness how much money/interest is garnered by apps like Instagram, Snapchat, WhatsApp (actually, arguably solving a real problem), and it's hard to argue we're not in a similarly idiotic bubble to the previous one. Of course, this also creates valuable stuff (my favourite recently being Slack), but I'd be willing to bet that this huge BS-to-usefulness ratio isn't sustainable in the long term. 0: http://techcrunch.com/2015/05/06/meerkat-founder-on-getting-the-kill-call-from-twitter/ http://techcrunch.com/2015/05/06/meerkat-founder-on-getting-... edit: instant downvote - if you don't just disagree with my tone, please explain why you think I'm wrong edit 2: I'm not saying I have an answer, but at least I tried to pick something that seemed worth doing (I work at Lavaboom, we're trying to make encrypted email easy to use - with extra privacy sprinkled on top)

PavleMiha 11y ago
I think the issue people have with your comment is that you seem to label things you don't use as stupid crap for stupid users. Snapchat, Instagram and WhatsApp solve a very real problem and are very useful for the hundreds of millions of people that use these services multiple times a day. It seems that you only label stuff as valuable if it solves problems you have (Slack and Lavaboom). I'm not a daily Instagram user, but some of my friends love it. They're not dumb, they just get more enjoyment out looking at and sharing pictures of cool shit and their friends.
- deleted 11y ago
  [deleted]
- AndrewKemendo 11y ago
  It seems that you only label stuff as valuable if it solves problems you have The idea that things that are popular are "solving a problem" is a really bad trend in my opinion. "A problem" is something that has generally identifiable boundaries and detrimental implications if not solved - for example not being able to send someone money is a problem, and one big enough that it warranted the creation of paypal and the like. I doubt highly that the millions of snapchat users at some point said "If only there were a service that deleted my pictures 10 seconds after I took them." The major differentiation in my mind between a service that "solves a problem" and another "bullshit service" is whether people are willing to pay for it. That's not to say you can't get rich off of bullshit, the E! network among others is proof of that, but lets not fool ourselves into thinking these things actually make the world better.

methodover 11y ago

Hm. As an engineer relatively new to the world of entrepreneurship, I find myself not really understanding much of the jargon. (Actually, I think I might understand some - but my confidence in my understanding is low.) It would be cool if there was like, an annotated version of this explaining some of the accounting/investing jargon. For example, this passage: Richard attracts Peter, a newly-wealthy budding angel investor, who agrees to put in $1 million as a note with a $5 million cap and a 20% discount. I think this means that Peter is buying part of Richard's company for 1 million bucks. He's valuing it at 5 million, so that's 20% of the company. However, there's a discount of 20%... Which is where I get confused. Does this mean that Peter is paying only 800,000, but getting 20%? Probably not, given the context. It probably means he gets 24% of the company, right? (He's getting 1.2M worth of shares for the cost of 1M.)

sokoloff 11y ago
You mostly have it. The $5MM is a cap, not a price. If the Series A is raised at $5MM or more valuation, then the angel gets his money ($1MM) converted at $4MM ($5MM * 0.8). If the Series A goes at $4MM, the angel's money is converted at a $3.2MM valuation (4*0.8)
- carrotleads 11y ago
  The 20% discount confused me too. Am I right then that the discount is to calculate the equity % based on a future Series A valuation. if so in the scenrio's you posted above what is the new Equity % for the angel. Looks like it is 20% once it crosses $5m cap as inferred in the article.
  - sokoloff 11y ago
    You forced me to look it up (thank you for that). It seems like either the cap xor the discount applies (investors' option), so anything over $6.25MM valuation, the cap would apply and anything under that the discount would apply. It's too late for me to edit the GP post, so I'll try to correct it here: At a $5MM priced round, the discount would apply and the investor's note would convert $1MM at a $4MM valuation (25%). I believe that conversion is done pre-money, which means the angel is diluted (like all shareholders) from their initial 25% by the addition of the new money. (None of my angel investments have [yet] raised a priced round, so I haven't gone through this process, though I obviously hope to... :) ) If someone else invests $1MM at $5MM pre-money valuation, all prior investors are diluted by 16.6667%. (Someone who held 10% of $5MM pre-money company will hold 8.333% of a $6MM company post-money. Either way, their position is worth $500K.) So, to know the angel's ownership in the scenario, you need to know how much dilution happened due to the new money, meaning you need to know not just the pre-money valuation, but also the amount of new investment money. In any scenario where the discount applies, the angel's position will be worth $1MM. In any scenario where the cap is better than the discount, the angel's position will be worth more than $1MM.

AndrewKemendo 11y ago

So what is the reasonable repeatable way to determine or gauge valuation? From what we have seen it is "Investor A wants X% of B and is willing to pay Z for it" therefore value is the multiple of Z that equals 100%. AkA Whatever someone will pay for it, AkA market prices. Except it's rarely a market in the traditional sense as it's really ever only a handful of buyers and they value it based on god knows what metrics. Seems flimsy and based on whatever the most recent investor thinks - due diligence best practices aside. We need a standard way to determine valuation so that founders and investors alike can point to something that is based in reality and can't be gamed as easily.

netcan 11y ago
Demanding a standard way to determine valuation is in some ways like demanding a standard way of coming up with ideas. The reason prices are determined this subjectively is because information is incomplete. That means you need to use a lot more one off judgements that can't be fit into a standard. If information was better then there would already be useful standards. There are pretty decent standards for companies that demonstrate a lot of consistency, like shipping companies. There are ways for valuing stock. On the other end of the spectrum, valuing a company that is still a work in progress is a different kind of problem. The upside is bigger and the downside more likely.
- AndrewKemendo 11y ago
  The reason prices are determined this subjectively is because information is incomplete. That is every market ever. No entity makes decisions based on perfect information - but plenty have a process that is auditable and lays out the assumptions. If information was better then there would already be useful standards. I think whatever standard or process we did come up with would be more refined/accurate with more information - but I that doesn't preclude having something that can be audited. I'm not saying that the process would spit out the "right" valuation, because that is impossible to tell prior to a liquidation event. What I am saying is that the process for determining valuations needs to be 100% more transparent. Like it or not there is a process - maybe it's all in one principle's head, but it's there. We as founders need to know what that is.

hackaflocka 11y ago

Great article. Would love a simple, colloquial explanation of the following phrases: * $1 million as a note with a $5 million cap and a 20% discount. * senior liquidity preference of 1x to protect their downside since they feel the valuation is rich * Peter, is stoked that he is getting his $1 million investment converted into roughly 20% * senior 1x liquidation preference * the preference overhang of $211 million * They ask prior investors to recap * the ‘overhang math’. * senior preference and a 2x guarantee. * waterfall spreadsheet

nirmel 11y ago
> $1 million as a note with a $5 million cap and a 20% discount. This refers to an investment done on a "convertible note." These particular terms mean that the valuation at which their investment will "convert" from what is nominally a loan into equity will be at most $5m, but if a subsequent investor invests in an equity financing at less than 6.25m, their investment will convert to equity at 20% less than the valuation. Read up on convertible notes for more detail. > senior liquidity preference of 1x to protect their downside since they feel the valuation is rich Means that in a sale, the investor will get the full amount (1x) of what they invested before others (i.e. founders, employees) see anything. > Peter, is stoked that he is getting his $1 million investment converted into roughly 20% Since the valuation was > 6.25m his valuation was capped at $5m, whereas the investors who are investing got a valuation of $40m "pre-money" or $50m "post-money" which are much less favorable terms than what Peter invested at. > the preference overhang of $211 million Means that if the company is to be acquired, it would take an acquisition offer of at least $211 million for founders and employees to see even a penny. That is because that amount was invested with the "1x" preference. > They ask prior investors to recap I think this means they are asking previous investors to lower the amount of liquidity preference they have such that in the event of a sale under $211m the founders would see some return. > the ‘overhang math’. The wiser employees understand the math that says an acquisition has to be enormous for them to see anything. If they don't think that's likely they will see little motivation to continue working at the company. > senior preference and a 2x guarantee. 2x guarantee means that they would be guaranteed twice the amount the invested in the event of a sale, possibly ahead of other investors, but I'm not sure. > waterfall spreadsheet Indicates how much each interested party would get in proceeds in the event of exits of various amounts. E.g. if company sells for X, investors get Y and founders get nothing. If company sells for Z, investors get X1 and founder gets Z. Etc.

api 11y ago

It seems obvious to me that giant valuation means insanely high bar before you see upside. I am a bit skeptical of the idea that it should be as high as possible, since if it's fundamentally ridiculous and there's no way you will ever live up to it I fail to see how this is in anyone's interest.

bshanks 11y ago

Hypothetically, assume a company whose valuation increases roughly geometrically at first, but then levels off at an asymptote, and assume that during the geometric phase the valuation fluctuates by 50% around its trend. Assume that no one knows where the asymptote is. Periodically, there are funding events, during which the company sells stock at a 1x liquidation preference; assume it sells enough stock so that at each funding event, the sum of the liquidation preferences is greater than 50% of its valuation. Consider a funding event that occurs when the valuation happens to be 25% above trend; therefore the liquidation preferences will be greater than 0.625 of the on-trend valuation, and then the next time that the valuation falls to 50% below trend, the sum of those preferences will be greater than the company's current valuation. At this point, many of those with liquidation preferences (some of whom may have a short time horizon; or may be risk-averse; or may believe that the current valuation will not rise very much in the future) may strongly prefer selling or liquidating the company immediately, which is at odds with common-stock-holders, who would get nothing in such a liquidation and who would prefer to keep going. Note that in this model, this result occurred not because of mismanagement, but due to the natural and expected fluctuation in market prices, combined with unavoidable uncertainty about which price changes are fluctuations and which are simply 'the new normal', combined with the sum of liquidation preferences being comparable in magnitude to the fluctuations in prices, combined with the bad luck of a funding event happening to occur when the valuation was above trend. Is this model reasonable? If so, how should management of such a company approach fundraising? It seems to me that fluctuations are inevitable and that the only thing management could control is how much money they raise at once; if fluctuations are 50% around trend, then management needs to keep the amount of money raised small enough so as to keep the sum of liqudiation preferences well under 1/3 of the current valuation (because in that case even if the valuation falls from 50% over trend to 50% under trend, the valuation will still be strictly greater than the sum of liquidation preferences). More realistically, the size of fluctuations would not be known in advance to be 50% but must be estimated. In the article, the valuation fluctuated from $1bil to $250mil, so the fluctuation parameter would be at least (1-x)/(1+x) = 250/1000 = 4 -> x = 3/5 = 60%, and the sum of liquidation prefs "should have" been kept well less than 250/1000 = 1/4 of the current valuation.

DonGateley 11y ago

Is there a good text which would make the meaning of all this clear?