
The Risk of a Billion-Dollar Valuation in Silicon Valley - JumpCrisscross
http://www.nytimes.com/2015/09/23/business/dealbook/the-risk-of-a-billion-dollar-valuation-in-silicon-valley.html?nlid=65508833&ref=dealbook
======
grellas
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.

~~~
philrapo
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%.

~~~
ryandamm
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.)

~~~
philrapo
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.

~~~
philrapo
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.

------
ClintEhrlich
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.

~~~
ghshephard
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.

~~~
ClintEhrlich
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.

------
ScottBurson
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).

~~~
SeoxyS
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.

~~~
chralieboy
> 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.

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mode80
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.

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

~~~
ClintEhrlich
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.

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

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neelm
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.

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

~~~
mahyarm
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.

~~~
ryandamm
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.)

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

~~~
otterley
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.

~~~
mahyarm
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.

------
AndrewKemendo
_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.

~~~
lukasm
PR, scare competition, generate deal heat, sell.

~~~
harryh
This is actually a pretty rare sequence of events.

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

~~~
dsjoerg
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...](http://www.inc.com/magazine/201411/lindsay-blakely/how-
jessica-alba-proved-her-doubters-were-wrong.html?cid=sf01001)

------
EA
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.

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jerf
"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.)

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

~~~
ScottBurson
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.

~~~
chetanahuja
_" 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.

------
notlisted
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...](http://www.businessinsider.com/how-liquidation-preferences-
work-2014-3)

------
memossy
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...](https://medium.com/@emad/asset-allocation-not-share-prices-will-
drive-vc-funding-723c0591d77c))

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

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vasilipupkin
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 ?

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arbitrage314
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.

------
Animats
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...](http://www.bloomberg.com/news/articles/2015-06-30/uber-bonds-term-
sheet-reveals-470-million-in-operating-losses)

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

~~~
Animats
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-...](http://www.zerohedge.com/news/2015-01-08/wsj-looks-non-gaap-
earnings-horrified-what-it-finds) [2] [http://gawker.com/here-are-the-
internal-documents-that-prove...](http://gawker.com/here-are-the-internal-
documents-that-prove-uber-is-a-mo-1704234157)

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

------
rajacombinator
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.

------
lquist
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...](http://nypost.com/2015/05/29/snapchat-has-sold-537m-in-common-stock-
to-investors/)

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ChuckMcM
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.

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ilzmastr
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?

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

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sutro
Money quote = "unicorpses"

