The Risk of a Billion-Dollar Valuation in Silicon Valley | Hacker News Reader

The Risk of a Billion-Dollar Valuation in Silicon Valley

nytimes.com

108 pointsJumpCrisscross78 comments

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.

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.

To put it another way, downside protection / insurance has value.

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.

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.

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.

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%.

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.)

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.

Yeah, the fact that they have to cite Honest Co. (not one of the big names), and that the liquidation preference works out to a tiny fraction of their current valuation, suggests to me this isn't a huge concern.

Then again, I don't know how transparent the financing is for these enormous companies, so maybe it is a bigger deal than I think. (I also don't lose too much sleep over it.)

Actually I have heard/read that it gets more common in very late stage (near-IPO) financing rounds as well. For example, when a company is expected to IPO in the next 12-18 months but needs some more cash runway, there are funds that specialize in providing this type of "bridge loan" financing, which often comes in the form of preferred stock with heavy liquidation prefs.

Sorry for not putting it more clearly. When I said that liquidation preferences do not drive up valuations, I meant (in the spirit of the article) that this is not an explanation for why valuations today are extraordinarily high for this number of companies as compared to prior eras when they also had liquidation preferences.

Of course, as your comment correctly points out, a liquidation preference has value, even immense value for its downside protection. And this value is reflected in the valuation. It just isn't the reason for a huge upward spike above the historical norm.

Hope this clarification helps.

I don't see where the article stated that this is the explanation for current valuations. Just that it "very likely pushes valuations even higher", which is an understatement if anything.

I don't think the impact is as great as many think. Unicorns and other companies headed in that direction almost never liquidate so the preference rarely comes into play meaning the valuations are more real than many think.

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-Th...

http://avc.com/2011/07/financing-options-preferred-stock/

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.

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

Viewed from the perspective of a founder, they are a serious annoyance. But from the perspective of the public at large, they are being exploited to engage in pseudo-fraud.

Right now, the world treats a company's 'valuation' as a reliable signal of information about how much investors actually believe the company is worth. That information is then integrated into heuristics that influence various people's decisions: Will a paper write about a startup? Will a reader pay attention? Will a recruit take the company seriously? A billion dollar valuation goes a long way in each circumstance.

The problem is that our collective intuitions are using an outdated algorithm for assessing value. In theory, VCs who invest at a given valuation are providing reliable information by putting their money where their mouth is. But in practice, liquidation preference means that the official valuations attached to their deals don't really reflect the limited risks they are taking on.

A VC who invests $10 million at $1 billion valuation may officially be signaling to the world that a company is valuable. But if he insists on a two-times liquidation preference, then he is really indicating that when the whole thing blows up he wants to make sure he can get the first $20 million.

Unfortunately, that information isn't broadcast the same way to outside decision makers. Even those of us who think that startups are grossly overvalued don't give enough thought to how illusory those valuations are to the very investors whose capital is fueling them.

I hope that will start to change.

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

True. The question is how much the VC thinks that accumulated advantage (in sociology, "the Mathew effect," according to which the rich get richer) means that an increased present valuation can increase the probability of future increases in value.

And if the VC thinks that the upside is big enough — e.g., the next Uber — then 1% equity could be worth a billion dollars in the foreseeable future.

The trick to black-swan farming is casting a big enough net. And liquidation-preference makes it possible to take more bets by significantly decreasing downside risk on each one.

Obviously, we are aren't dealing with a linear relationship. Once companies reach a certain valuation, the prospects for future growth are significantly reduced. But there may be an intermediate stage where the benefits to the company are significant enough that the VC's probable ROI increases by investing at a higher valuation.

A VC who really wants to game the system should make a large seed investment at a low valuation, and then make smaller investments in later rounds at intentionally inflated valuations.

This article talks a lot about the effects of preferences on the founders, but doesn't mention the employees, who get an even worse deal because their upside wasn't that big to start with.

Maybe at some point founders will start to refuse deals involving preferences, even at the expense of valuation and/or amount raised, in order to be able to offer their employees a better deal (and thus attract better employees).

That would require employees to actually understand how venture financing and liquidation preferences work, which is rare in my experience. Then a smart company could broadcast its lack of liquidation preference as a recruiting tool.

It's hard enough to raise money without trying to get out of standard terms like liquidation preference though. And pretty much zero Series Seed/A companies are so incredibly attractive that they'd have enough leverage.

So while I am hopeful like you, I can't really see it happening.

Liquidation preferences are a hugely important term that protects investors from being screwed over by founders. Without it, nothing stops an unethical founder from raising 800k at a 8M cap, and turning right around and letting the company get acqui-hired for 4M a month later, pocketing $3.6M and leaving the investors with half their money.

With a liquidation preference; investors get their money back, the founders take their $3.2M, and nobody walks away feeling screwed over.

[Note: this example works exactly the same if you multiply the numbers by 100.]

As an investor; I don't invest unless I have 1x liquidation preference and pro-rata rights. These terms are standard because they're fair and they're critical for protecting the investor.

that's why the article is so ridiculous. VC doesn't make sense without liquidation preference, so founders would be MORE screwed without it because they would not have any funding for their startups !

> nothing stops an unethical founder from raising 800k at a 8M cap, and turning right around and letting the company get acqui-hired for 4M a month later, pocketing $3.6M and leaving the investors with half their money.

Except that they just exchanged a stake worth $7.2m and sold it for $3.2m. Founders with large stock options are _more_ incentivized than even investors to maximize valuation in the event of a sale.

I understand that you want to make a bet while minimizing risk, but if you're going to try and guarantee your money back then as a company I'm going to price that in by minimizing the upside.

Without liquidation preferences, you as an investor can negotiate more reasonable valuations (if you're setting a cap of $8m and the company is willing to take a $4m buyout, you've seriously mispriced the company.) That means more potential upside.

> Without [liquidation preferences], nothing stops an unethical founder from raising 800k at a 8M cap, and turning right around and letting the company get acqui-hired for 4M a month later, pocketing $3.6M and leaving the investors with half their money.

Of course there is something to stop this: membership on the board of directors. Large investors should -- and usually do -- demand board seats so that they have representation in major decisions such as this.

The article makes it sound like a liquidation preference is some new phenomenon that explains the recent surge of ostensible $1B valuations. In fact this has been a standard deal term since the 90s.

Just because it existed in the past shouldn't discount it's effects in the present as evidenced in the side effects of medicines.

The fact that liquidation preference has been standard in term sheets for decades mean that its advent cannot have caused the recent inflated valuations. But the way that VCs are employing liquidation preference may have changed. For example, the liquidation-preference term may have increased in importance if IPOs are becoming less common relative to other liquidation events or if out-of-control valuations mean that liquidation-preference is a more important form of protection than it used to be.

I agree with you. My argument was against altogether discouting Liquidation Preference as a suspect in higher evaluation by stating its existence in '90s.

One of the reasons that you hear CEO's want a $B valuation is that it becomes "easier to attract top talent". I'm not sure that is valid. You want talent that believes in your mission. Not all $B valued companies have the same risk/reward scenario. It'd be helpful to have some metric of the capital efficiency a company has to get to the $B mark.

The one good side effect is that private investors are taking all of the risk. If there is an adjustment in valuations across the industry, it should not effect the public markets the way it did in 2000. It could however impact the LP market and the number/size of VC funds could go through another cycle.

  If there is an adjustment in valuations across the industry, 
  it should not effect the public markets the way it did in 2000.

Isn't this only in the case where the said unicorn is not IPO'd. Like in the case with Groupon which lost 85% of it's value since IPO, the public market is affected.

If these 59 unicorns go public and begin to loose money, they would effectively trigger a domino I believe.

Like the VCs who get in during the E/F rounds, the general public is also susceptible to similar behavior.

Yes that is true. You're exposing an assumption of mine which is that many of these companies will not necessarily IPO.

However even when they do, they will be a lot more operating history and financial information than what companies typically had in 2000. This is why you're seeing some recent tech IPOs that went public at a valuation lower than their last private round. An example of this is Hortonworks.

I hope this becomes the norm but I'm a bit wary as IPO conversion provisions [0] may come into play.

[0] https://www.fenwick.com/publications/pages/the-terms-behind-...

Top talent wants a low valuation so that stock options can provide a big payout.

Plus: Anyone who is "top talent" is probably well aware of the negative effect of liquidation preferences on employee common stock value in an acquisition (the topic of the article). So $1B valuations with heavy liquidation preferences are not a good thing to these folks.

However liquidation preferences are opaque to candidates, so "top talent" just has to assume there are liquidation preferences on all companies.

Those terms are very material to a candidate's compensation package; maybe they should be made known. (Honesty and transparency?!)

So should this mean talent should be discounting equity when negotiating deals with still-private companies? If so, how much?

Yes. Not always easy to answer. Some factor of revenue growth, margins, how much capital the company has already raised, understanding the burn rate, how much has been spent vs dry powder, liquidation preferences assumption. Probably a lot I'm missing. There should be an easier way for a prospect to simulate a cap table with a simple set of assumptions.

A good first approximation is to regard your after-tax equity upside == 0 in all ventures that you didn't found.

Once your become a $1B+ startup, your options for liquidity events reduce greatly. Fewer and fewer markets can buy your company. Often when a company has a high valuation, people think it's 'too late' to join the unicorn. If the company isn't profitable on some level yet either, it's even worse.

This is a severely under-appreciated situation. One has to wonder how many good employees a company misses out on because the traditional style of Silicon Valley capitalism is to be one of the first 20 people in the company or you'll be clawing for scraps like the next 2,000.

Is there an opportunity for any meaningful equity/options when joining a company that size? Or should candidates be focused on salary and other benefits at that size?

Absolutely. In fact it's somewhat better. If you join a big company like that, they're not going to be able to give you 1% of mythical future company value, but they CAN give you X shares now with very real value. If you join a 500-2000 person company with a $1B+ valuation and stick it out for four years of hard work and promotions - you can easily be looking at a $500k-$2M payout (above and beyond your high salary). More is possible too. This is why even giants like Facebook and Google can still attract top engineers - they can give you equity that's basically equivalent to cash - and lots of it.

Joining a smaller company gives you the chance at a massive payout of $10M+ - but I'd bet your 4-year "expected value" would be much less than joining a bigger company. For one - your options are going to be worth anywhere between $0 and $1B - but heavily weighted towards zero. Two - you have to actually buy your options with cash, which reduces mobility because this is very risky! This often costs $20k or more. So you may leave your options on the table. Very few people would be leaving options on the table at somewhere like Uber today if they quit. You'd find the money and buy your shares. Three - your potential exits are numerous but many of them are the sort of deals that kind of devalue your equity to near worthless (due to LP) and instead buy the team with employment offers and new golden handcuffs - which can be highly variable. An IPO or mega acquisition is a clean transaction for common stock holders.

This is a good point. The converse is also true, though: high valuation means you have lots of dollar-valued equity to use to entice possible employees. And that scales with your valuation.

Fun fact, a friend was complaining to me about how hard it is to hire Android engineers, because he keeps getting outbid by Uber. He's at a public company, by the way, but couldn't match their pay packages (including ~$1m in stock options).

Yes, you won't necessarily see the same crazy run up in stock value as if you joined at the ground floor, and yes, you'll owe taxes on the nominal value of the option price, etc... but that's still a lot of money, and it's arguably de-risked relative to an A-series startup. (Then again, if the company you're looking at isn't profitable, maybe it's not de-risked... buyer/employee beware.)

Uber is a bit of a special case. It's basically the next potential facebook / google.

If you join Uber at this point, you're only getting RSUs, not equity. They're way too large to offer shares to any more employees without triggering SEC disclosure requirements.

TBH, RSUs are better if you cannot afford to early exercise. Otherwise you have the 90 day option expiry problem after leaving your job, unlike most RSUs. Options also get bad with AMT tax if you didn't early exercise either. RSUs stay with you even after you leave the company.

Oh well, you lose long term capital gains tax benefits, but most people do not have the money to even exercise their vested options, so they sell during IPO and have equivalent tax treatment as an RSU.

Some companies now have option expiry dates at 7 years, but those can be counted on one hand.

This is highly situational. I would love if the best of "X" type employee out there were all hunting for 2-5M valuation (or whatever you consider low) startups - but that isn't as common. Many people are risk averse.

I think part of this scenario is that companies raising tens or hundreds of millions at billion++ valuations are hiring "scaling talent".

Scaling as in hiring many good to great people, but lots of them, some of whom overlap. Multiple product managers, many great engineers, great heads of sales/ HR/ operations.

Oftentimes they are focused on becoming huge, scalable, consistently growing revenue generating operations.

> The one good side effect is that private investors are taking all of the risk. If there is an adjustment in valuations across the industry, it should not effect the public markets the way it did in 2000.

I'm not so confident about this. One of the reasons the 2000 correction was so dramatic was how interconnected tech revenues had become. Startup A had revenue because startups B and C were customers. When B went under, A started to have trouble. Then A goes under, so C loses their customers who were being paid by A, and so on. Revenues were basically a shell game funded by VCs.

This pattern looks like it's repeating itself. Look at public companies like Facebook and Twitter: huge portions of their ad revenues come from app install ads. It's safe to assume that a lot of those ad buys wouldn't be happening without VC funding. How about IaaS/PaaS providers? Same story. There will still be customers for many of these products if the bubble pops, but how well can these companies handle a rapid reduction in demand? And then there are ripple effects. How will commercial REITs fare? How will consumer spending be effected when people currently earning inflated salaries paid for by VC money suddenly can't find a job?

At this point it's all one big hypothetical, but I would hesitate to assume that a correction will be limited to the private market. The public market has plenty of exposure to the private bubble by proxy.

Source?

A lot of app install ads are from companies with solid revenue streams that are not startups. A lot are also for mobile games monetizing (oftentimes quite profitably) off IAP.

I feel like there is a common claim floating around that a lot of the big tech companies in the advertising industry (Google, FB, Twitter, etc.) are going to take a huge hit if something causes funding to dry up for startups.

I have yet to see anything material indicating that a notable portion of their ad revenue is driven by such companies. Are these companies spending with them? Sure. But in terms of absolute dollars and total % of revenue, my assumption would be it is a drop in the bucket compared to large established brands like CPG companies, clothing companies, auto companies, etc.

I might agree about ads, but not IaaS.

Let's say a company gets $10M in funding. It's hard to see how it can spend more than $100K/year on IaaS. On the other hand, there are plenty of blue-chip companies spending $millions on IaaS. (i.e. Try to do drug research without it.)

And even if all VC money went away, for every VC funded company, there are 100 startups using 1/100th of IaaS.

With liquidation preferences, you can offer the venture capitalist a $1 billion valuation with the pitch that the liquidation preference will protect the investor on the downside.

Other than a vanity metric, which the press will run with for a short time, is there any financial benefit to trying to game a $1 BN valuation? Doesn't seem like it would make any aspect of running the company easier or smoother and would make a merger/acquisition even less likely. Since there is no direct liquidity in it either (unlike stock), unless the founders took money off the table, the founder doesn't materially benefit any more than they would have otherwise.

It seems like if you need multiple preferences to get to a specific valuation (as the article alludes to) then the risk does not match the fundamentals of the company.

Maybe this is just beating a dead horse though about how companies are not being valued on fundamentals, though in that case which ones to use is itself a contentious debate.

PR, scare competition, generate deal heat, sell.

This is actually a pretty rare sequence of events.

Is no one talking about how Jessica Alba is a founder at a 1.7 billion dollar start-up?!?!

Agreed, that is interesting. Here's a puff-piece interview, she says the right things and says them well: http://www.inc.com/magazine/201411/lindsay-blakely/how-jessi...

Oh wow, I read the article and completely missed that. They were talking about the TV show "Silicon Valley" just a few sentences before mentioning her, and I assumed that they were describing a fictional startup with her playing the founder.

I'd like to see a website where you can select from a list of companies, select a start date on a timeline, and select a role (founder, CTO, engineer, etc.), a salary and benefits (stock) package to see how you'd make out at different times on the timeline.

"Some unicorns, like Honest Company, have terms that require minimum I.P.O. prices for the V.C. investors that they just won’t be able to meet anytime soon. According to Fenwick & West, 19 percent of the unicorns in their survey had such minimum price protection."

As a total outsider, this is the first I've heard of this clause. Is this also a significant contributor to the much, much later IPOs? (I mean, in reality, not in theory. The theory is obvious: "yes", but the theory doesn't prove a particular significance.)

That's a question that probably won't be answerable for at least a decade.

How they can guarantee a minimum IPO price? Isn't that decided by the market?

The market decides the price, but the company decides the timing. Any IPO is postponed until it is clear the minimum price can be obtained.

"The market decides the price"

Well, not quite the market... just the undertak... I mean underwriters. Which is not quite as open-markety a process as one might assume.

There was an article about liquidation preferences and the impact on employees (incl. CEO) a few years ago that every startup employee should read to properly evaluate the package they receive.

http://www.businessinsider.com/how-liquidation-preferences-w...

It is a combination of liquidation preferences & far more money going into the private market as there are fewer "investable" options in the public market & asset allocation becomes broader (a trend I see continuing: https://medium.com/@emad/asset-allocation-not-share-prices-w...)

This is why you see hedge funds, family offices etc playing the $100m+ round space as Andreesen Horowitz for example showed in their recent funding report.

This is different to prior instances as there was less money available in the private market at this stage as typically public markets were seen as the preferred venue

A final few reasons were a) higher interest rates at prior times which made convertible notes/bonds not as attractive versus an equity IPO round and b) IPOs provided liquidity events that you can emulate now

This article to me is a perfect example of bias in the media. It takes something commonplace and reasonable and explains it in a way that makes it sound vaguely nefarious. Why ? Because many NYTimes readers already have a vague anti business bias, is the only explanation I can think of. Or is it just clickbait tactics ?

I don't think there's that much to worry about. If a VC wants a liquidation preference, that's fine--they'll have to pay for it by giving me a better valuation (in other words, giving me money money more cheaply).

The market corrects for all of these kinds of things.

Some of those "unicorns" are going to die. Way too many minor companies now have "billion dollar valuations". There's some company with a single-signon service with a "billion dollar" valuation. Uber had $470 million in operating losses on $415 million in revenue, according to figures in a bond prospectus reported by Bloomberg in June.[1]

[] http://www.bloomberg.com/news/articles/2015-06-30/uber-bonds...

That was 2014 IIRC. Uber will do 2bn gross this year and 5-6bn gross next year. Their financials are pretty strong.

When Uber publishes audited GAAP numbers, we'll know. Non-GAAP numbers are total junk.[1] Uber's latest "leaked" numbers still show losses.[2]

[1] http://www.zerohedge.com/news/2015-01-08/wsj-looks-non-gaap-... [2] http://gawker.com/here-are-the-internal-documents-that-prove...

Of course they're going to be spending/losing. Why else raise 8bn? To grow.

Hopefully the recent focus on liquidation prefs is a sign they're on the way out. Definitely a holdover from the "screw the entrepreneur" era of VC.

One notable exception is Snapchat which recently raised ~$500M selling common shares instead of standard preferred shares.

http://nypost.com/2015/05/29/snapchat-has-sold-537m-in-commo...

I thought that was an excellent overview of the challenges of taking too much money. (and unicorpses was a new word, I suppose once dead (or undead) they are no longer Unicorns) I think there is also an interesting retention effect on founders who have stock that is worth millions on paper if they make it work, and worthless if they don't.

So does this mean that although $Bb valuations sound like we're in a bull market, it really means we're in a bear market where investors prefer downside protection over a larger share in the upside?

Since very few of the unicorns are going to liquidate, I wonder how much this preference actually skews valuations?

Money quote = "unicorpses"

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