
The Terms Behind the Unicorn Valuations - zeeshanm
http://www.fenwick.com/publications/pages/the-terms-behind-the-unicorn-valuations.aspx
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fsk
Suppose pre-financing, the company is worth $5M, and no matter how bad things
go, it'll never fall below $1M. (due to patents, brand name recognition, the
VC's ability to arrange an acqui-hire, or whatever)

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.

~~~
ykumar6
In the article posted, participating liquidation preferences (like you
mention) seem extremely rare.

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fsk
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.

~~~
jalonso510
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.

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jalonso510
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.

~~~
joshjkim
+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.

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matthewmcg
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.

~~~
hkhanna
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.

~~~
jalonso510
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.

~~~
matthewmcg
Right, that's been my experience as well (seeing mostly financings of
companies in the southeast US).

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jpmattia
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.

~~~
cfield
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.

~~~
joshjkim
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.

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brianmcconnell
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.

~~~
btilly
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.

~~~
drinkzima
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%"

~~~
btilly
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.

~~~
URSpider94
There are many kinds of exit. IPO is only one, and is not the most common.

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nugget
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.

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some1else
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?

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cma
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](https://news.ycombinator.com/item?id=6896833)

~~~
some1else
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.

