Protections for Late Investors Can Inflate Startup Valuations | Hacker News Reader

Protections for Late Investors Can Inflate Startup Valuations

nytimes.com

35 pointsmuzz16 comments

tl;dr Startup valuations are usually calculated by multiplying the number of issued shares by the price paid at the last round. This can overestimate the valuation if there are different classes of shares, and the most recent shares have more rights (e.g. liquidation preferences or discounts on future rounds) than do those issued earlier.

I don't know the answer, but doesn't that have to come out in the valuation employees are given? Since there are huge tax penalties both to the employer and the employee for giving in-the-money options, you (in theory) must be given options with a strike set by a 409a evaluation. I think it's best practice to have an arms-length evaluation, since if your cfo sets it and the irs disagrees, see tax penalties. Is this not the state of the world?

Yep. Everyone ponies up and pays the $10k/year for the 409a consultants -- in theory, their calculations to establish the option value takes into account all of the liquidation preferences of preferred shareholders but anyone that's been through it can tell you how arbitrary the 409a's really are.

pg: "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

Suppose an investor pays $100M at a valuation of $1B with a 1x liquidation preference.

Then the REAL valuation of the business is not $1B. It's whatever the investor would have paid for COMMON shares.

The article mentions that companies could increase their valuations by increasing the number of shares in the option pool. But how would that work? I'm not seeing the math on that.

a lot of this sounds like three comma club problems, however, I'm' trying to connect the dots between the discounts offered to late stage investors and how that affects my one comma club friends and family ..help?

When a late-stage investor gets to invest with a liquidation preference, that can ruin the value of the common shareholders (i.e., early employees) if the startup is not eventually sold for an even bigger valuation.

I.e., the early employees do a great job. The business has a value of $100M and their non-liquid shares are worth $0.5M. The business raises $100M with a 1x liquidation preference. The startup fails, and eventually sells for $50M. Instead of getting $0.1M-$0.25M, those early employees get nothing.

but aren't the unicorns headed for ipo? ..in that case seems anyone with stock options probably does well if the stock doesnt completely tank ?

lotsa folks don't think that many unicorns will actually IPO - here's a good read that summarizes the potential issues: http://abovethecrowd.com/2015/02/25/investors-beware/

That's really solid article and anyone who has their head in the fundraising game right now should go read it. Thanks for posting it man.

thanks -- this does provide some clarification.

A lot of the unicorns appear to have problems: they have a high valuation (probably good), but not the underlying revenue to support it (bad). With a few exceptions such as Uber and probably AirBnB, people are still buying on the hope of future growth. Or as Ceglowski would say, investory storytime.

Further, never forget that employees are plebes, and your and my shares are subject to a 6 month lockup that, for example, founders aren't necessarily subject to. See Mark Pincus dumping 16.5m shares of stock for $11.64 ($190m) two months before, and for $3.18 more, than regular employees could [1]. Zuckerberg also sold 6% of fb at ipo, though since the price didn't cater investors don't seem to object. Founders often can also take cash off the table. Note that I don't necessarily think that's bad, but as in the cases of Secret and Digg, employees don't walk away from failed companies with millions.

edit: actually, Pincus appears to have sold at twice the price available to employees ($12 vs $6.09), not $11.64 vs $8.46.

   On April 3, 2012, the secondary offering closed at a price of $12.00. Mark 
   Pincus, Zynga’s founder and a director, netted approximately $192 million in 
   proceeds; the other three selling Zynga directors sold several million 
   dollars each in the secondary offering. Zynga’s stock declined significantly 
   following the secondary offering to a closing price of $6.09 on the date 
   that the original lockup restrictions ended, and a closing price of $5.36 
   and $3.00 per share, respectively, on the two extended lockup periods 
   applicable to the selling Zynga directors. [2]

[1] http://www.law360.com/articles/596929/zynga-founder-can-t-sl...

[2] http://www.law360.com/articles/608007/a-closer-look-at-delaw...

>but as in the cases of Secret and Digg,

Did Kevin Rose sell shares in Digg?

yes

https://gigaom.com/2008/09/24/digg-raises-28-million-in-seri...

Frankly it is a bit weird way to describe it. It is not some quirks of liquidation preferences that "ruined" it.

It is ruined by a simple fact that this hypothetical startup earned just 50 cents for every dollar raised -- I don't think anyone should expect a nice payout here.

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