The Terms Behind the Unicorn Valuations(fenwick.com)
fenwick.com
The Terms Behind the Unicorn Valuations
http://www.fenwick.com/publications/pages/the-terms-behind-the-unicorn-valuations.aspx
8 comments
In the article posted, participating liquidation preferences (like you mention) seem extremely rare.
Even with 2x straight preference, valuations don't matter much, provided the residual value of the company on failure is close to the amount you're investing.
2x preference is way off market these days. Most financings are 1x non-participating. The linked study says they saw multiple preference in 3% of the unicorn deals.
Exactly right. Sometimes the 'haircut' is really only felt by the founders.
Recovering startup lawyer here....
The terms they are pointing out here are basically the same as you'd find in any equity financing post seed round. Seems strange to flag such common terms as evidence that there's something strange about these high-valuation financings.
The terms they are pointing out here are basically the same as you'd find in any equity financing post seed round. Seems strange to flag such common terms as evidence that there's something strange about these high-valuation financings.
+1 - I would say this reports deviates almost zero from any priced round I've done. All get 1X liq. pref, usually not-participating.
In fact, the only times I've seen participating or more than 1X preference is during a down-round or for a struggling company, aka. the opposite of a unicorn.
Weird.
In fact, the only times I've seen participating or more than 1X preference is during a down-round or for a struggling company, aka. the opposite of a unicorn.
Weird.
Interesting. The likely source for these data are the companies' corporate charters. These are all available to the public at the Delaware Secretary of State's office.
You can tell because they only discuss terms that go in the charter. Other things like registration rights go in separate contracts between the company and its outside investors.
You can tell because they only discuss terms that go in the charter. Other things like registration rights go in separate contracts between the company and its outside investors.
Do you know if there is any trend towards Delaware-incorporated startups including the "blank check preferred" provisions in their charter (DGCL Section 151). This would allow the Board to create new preferred shares by resolution, as opposed to placing the terms directly in the publicly-filed charter.
I am not too familiar with the industry, but if the trend is indeed to include such blank check preferred provisions, access to these terms would not be publicly available, and Fenwick may simply be drawing on its first-hand experience.
I am not too familiar with the industry, but if the trend is indeed to include such blank check preferred provisions, access to these terms would not be publicly available, and Fenwick may simply be drawing on its first-hand experience.
It's really uncommon to authorize blank check preferred. That's an interesting idea to keep things confidential, but the major stockholders will care more about maintaining the power over the authorization of new shares.
Blank check preferred is only really used, as far as I have heard, as a takeover defense for public companies worried about hostile takeovers, and even there I don't think it's that common anymore.
Blank check preferred is only really used, as far as I have heard, as a takeover defense for public companies worried about hostile takeovers, and even there I don't think it's that common anymore.
Right, that's been my experience as well (seeing mostly financings of companies in the southeast US).
It's relatively rare, but even so the board has to file a Certificate of Designation to use it, which would be publicly available to the exact same degree as a Certificate of Incorporation.
Yes, interesting. Looks like for 20 bucks one can get franchise tax assessment, current filing history, etc. for any company.
Can anyone point to a deal where liquidation prefs are exercised? Because any buyer would have to be crazy to let those stay in place. (If you're buying for a price that the liquidation kicks in, then it's not a giant success and there are usually a dearth of options for the investors so they'd rather cave on the liquidation prefs than no deal.)
It used to be that they were terms for throwaway during acquisition, but perhaps things have changed.
It used to be that they were terms for throwaway during acquisition, but perhaps things have changed.
The buyer shouldn't care if they are in place or not. In many ways it is better for the buyer because they know the employees didn't get a payout. Now the employees are more likely to stay on with the buyer instead of "calling in rich".
> The buyer shouldn't care if they are in place or not
Sure I do. Given a finite pot of money, I want 100% of it to go into incentive-based payouts. If the new company doesn't hit the goals, then I didn't lose so much money on the acquisition.
If the money pot went to feathering the nest of the investors and the acquisition doesn't work, then I've lost the entire pot.
Sure I do. Given a finite pot of money, I want 100% of it to go into incentive-based payouts. If the new company doesn't hit the goals, then I didn't lose so much money on the acquisition.
If the money pot went to feathering the nest of the investors and the acquisition doesn't work, then I've lost the entire pot.
Then you won't get the chance to be the buyer. If the business is doing well, owners will want you to pay for it and won't accept your integration risk. If the company is struggling, they won't give up their preferences.
empirically, incentive payouts are a great way to cause lawsuits and get the founders to hate you.
I don't think this has ever been a throwaway term during an acquisition in cases where the investors proceeds were higher under their liquidation preference rights than they would have been under their pro rata stockholder rights.
Thinking back over all such deals I worked on as a startup attorney, I can't think of a single one where the liquidation preferences were not asserted by the preferred stockholders (i.e., investors).
The selling owners generally view it as a buyer's problem to figure out retention, which is usually accomplished by the buyer making equity grants to the team that vest over time following the acquisition.
Sellers sometimes have a similar incentive issue -- i.e., they need to incentivize a team whose equity will be worthless in an acquisition. This is often accomplished by some form of "management incentive plan" which can have all sorts of structures. But the gist is typically to set aside some of the acquisition proceeds for distribution to key employees or management.
Thinking back over all such deals I worked on as a startup attorney, I can't think of a single one where the liquidation preferences were not asserted by the preferred stockholders (i.e., investors).
The selling owners generally view it as a buyer's problem to figure out retention, which is usually accomplished by the buyer making equity grants to the team that vest over time following the acquisition.
Sellers sometimes have a similar incentive issue -- i.e., they need to incentivize a team whose equity will be worthless in an acquisition. This is often accomplished by some form of "management incentive plan" which can have all sorts of structures. But the gist is typically to set aside some of the acquisition proceeds for distribution to key employees or management.
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My experience is in line with yours - investors always assert liq pref when they can, have never seen them give much on it. I've seen preferred throw common a few cents on the share, but usually it's zero.
Trados is a famous one:
https://www.wsgr.com/WSGR/Display.aspx?SectionName=publicati...
Basically, Trados got sold, preferred got their liquidation preference and common stock got zero dollars. Common stockholder sued saying that they should have held out for a deal that gave Common some $$ and that the board (which was controlled by preferred) violated their duty to common, but DE court said that the board + preferred were OK to do the deal.
Usually this is happening mid or later stage, where a once hot company is flat or declining, and the preferred holders control the majority of the board and the company (and sometimes the founder is already gone), in which case the preferred holders effectively control the decision entirely.
Basically, Trados got sold, preferred got their liquidation preference and common stock got zero dollars. Common stockholder sued saying that they should have held out for a deal that gave Common some $$ and that the board (which was controlled by preferred) violated their duty to common, but DE court said that the board + preferred were OK to do the deal.
Usually this is happening mid or later stage, where a once hot company is flat or declining, and the preferred holders control the majority of the board and the company (and sometimes the founder is already gone), in which case the preferred holders effectively control the decision entirely.
FTL:
> The remaining $52.2 million was distributed to holders of the company's preferred stock—less than their total liquidation preference of $57.9 million
I'm not sure that's different than my point. $7.8M for the current employees/management, most of which should have gone to fill liq prefs. What am I missing?
> The remaining $52.2 million was distributed to holders of the company's preferred stock—less than their total liquidation preference of $57.9 million
I'm not sure that's different than my point. $7.8M for the current employees/management, most of which should have gone to fill liq prefs. What am I missing?
So the preferred investors still get 100% of their investment even if the valuation goes down 90%? If that's the case, these valuations are completely fictitious.
No surprise there. I always assumed someone had come up with a new way to manipulate perceived value. Back in the dot com bubble they did that via extremely thin floats in IPOs.
No surprise there. I always assumed someone had come up with a new way to manipulate perceived value. Back in the dot com bubble they did that via extremely thin floats in IPOs.
According to the article, only 30% of deals had any specific downside protection.
That means that for the most part, the investors are betting that the company is actually worth at least what they are investing in it at.
That means that for the most part, the investors are betting that the company is actually worth at least what they are investing in it at.
Not sure what you mean, seniority is downside protection. To quote the article:
"Acquisition Protection Terms
Liquidation protection over common stock – 100%
Senior liquidation protection over other series of preferred stock - 19%"
"Acquisition Protection Terms
Liquidation protection over common stock – 100%
Senior liquidation protection over other series of preferred stock - 19%"
I was being sloppy, but am referring to the following sentence in the article.
Approximately 30% of unicorn investors had significant protection against a down round IPO.
So you're right. If the company goes bankrupt, unicorn investors are going to be first in line to get their money back. This matters, and does help get funding at higher valuation.
But it is not nearly as inflationary as terms that say that the investor still gets paid on a successful exit that is merely not as good as hoped. And the latter is the kind of term that could cause the valuation placed in the company to be totally disconnected from the value that the investor thinks the company should be worth.
Approximately 30% of unicorn investors had significant protection against a down round IPO.
So you're right. If the company goes bankrupt, unicorn investors are going to be first in line to get their money back. This matters, and does help get funding at higher valuation.
But it is not nearly as inflationary as terms that say that the investor still gets paid on a successful exit that is merely not as good as hoped. And the latter is the kind of term that could cause the valuation placed in the company to be totally disconnected from the value that the investor thinks the company should be worth.
There are many kinds of exit. IPO is only one, and is not the most common.
I wouldn't say "completely fictitious". Since the downside protection almost never (never?) comes into play at this stage, the investor's upside is indeed locked to the valuation.
Another way to value these Unicorns is to look at common stock sold on the secondary markets which has no preference attached. Based on the deal flow I see, I am guessing Pinterest could sell hundreds of millions of dollars worth of common at 8 or 9 billion in valuation. I think a new preferred round would be in the low teens billions for them. So some discount but not a huge one.
So now that even my high school friends are on the lookout for these big IPOs, they might not happen so fast, because the companies will have to really bring in the revenues to justify those valuations before going to market?
The reason valuations jumped so high is because the 'unicorns' and the rest of the SaaS sector have gotten so much better at capturing value. Obviously that's not a bubble scenario. However, there will need to be an adjustment period where these companies are hitting their targets, or they face to loose some value immediately after the IPOs. Does that make sense? Is that bad at all?
pg head scratcher:
"Yes, investors with preferred stock usually get their money back first. Sometimes they get a multiple, but that's considered overreaching nowadays and the more promising startups never have to agree to that. I suppose that is implicitly a target valuation in a sense. But no one views it as a target, because it only matters if things go badly."
https://news.ycombinator.com/item?id=6896833
"Yes, investors with preferred stock usually get their money back first. Sometimes they get a multiple, but that's considered overreaching nowadays and the more promising startups never have to agree to that. I suppose that is implicitly a target valuation in a sense. But no one views it as a target, because it only matters if things go badly."
https://news.ycombinator.com/item?id=6896833
Exactly. Most of these companies are in great shape. But there will be a few where investors with preferred stock will pull out, resulting in stifled growth and agility. For highly competitive and Thielesque-monopoly situations that might spell defeat, resulting in loss of faith from common stock holders as well. Lots of value will be lost in one place, but that's more a result of scale, not artificial inflation. Moreover, it will not signal a bubble burst for the rest of the industry. I wish it could even promote less speculative behavior.
If you invest $1M with a 2x liquidation preference, the valuation doesn't matter. You're guaranteed $1M back no matter what. If it's a home run, you still get the upside.
When you get a 2x liquidation preference, you can afford to invest at a much higher valuation than the "real" valuation of $5M, because your downside is limited, and you get a greater share of any upside (especially if you got participating preferred). Even on a fire sale for $2M, you still got a 100% return on your investment. Instead of selling $1M of common shares at a valuation of $5M, they can raise $1M of 2x preferred at a valuation of $10M-$20M+.
A lot of these valuations are funny money, because the headline doesn't mention the preferences given to the investment. If they were selling common shares, it'd be a much lower valuation.