The Terms Behind the Unicorn Valuations
fenwick.com
fenwick.com
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.
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.
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.
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.
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.
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.
It used to be that they were terms for throwaway during acquisition, but perhaps things have changed.
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.
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.
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.
> 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?
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.
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.
"Acquisition Protection Terms
Liquidation protection over common stock – 100%
Senior liquidation protection over other series of preferred stock - 19%"
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.
"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."