The Risk of Billion Dollar Valuations in Silicon Valley

The liquidation preference usually demanded by investors means that entrepreneurs are selling the hope in order to finance the dream. JL

Steven Solomon reports in DealBook:

As these valuations go up and down, remember that reaching a $1 billion valuation is not all good news for a start-up. Instead, it can simply mean that the newly foaled unicorn has made a Faustian bargain.

Deep inside a Silicon Valley unicorn lurks a time bomb.

It is a peculiarity of venture capital financing that the engine that pumps money into a promising start-up can later cause the same start-up to self-destruct. With all the hoopla and debate over sky-high valuations of technology start-ups, it is worth keeping in mind that the switch that helps to drive those surging valuations can also be turned off.

The “bomb,” so to speak, is known as a liquidation preference. In every financing round, the money that a venture capital firm invests is not given freely. The firm and the start-up will negotiate terms of protection.

Negotiable terms include voting rights, seats on the start-up’s board and assurances that a future fund-raising won’t unduly dilute the venture capital firms’ stake.

The liquidation preference is among the most important of these protections.

This feature provides that the venture capital firm’s investment will be repaid before the founders and employees are rewarded. If the firm has particular leverage, it can negotiate an even more protective form, known as the senior liquidation preference, which provides that the firm will be paid not only before the common stockholders but also before anyone else who bought preferred stock in earlier rounds.

These provisions apply in a sale but not in an initial public offering of stock. The idea is to ensure that even if the investment does not perform well, the venture investor will still get back its initial money.

According to a recent survey by the law firm Fenwick & West of 37 unicorns — private companies with valuations of $1 billion or more — every investment had a liquidation preference.

Let’s reflect on this. In the public markets, you invest your money and there is no guarantee what return you will get. But in Silicon Valley, you can get a guarantee of minimum proceeds in any sale, over and above what other investors receive. It’s a sweet deal, and it goes a long way toward explaining why venture capital firms are comfortable with lofty valuations.

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Such a guarantee very likely pushes valuations even higher.

For example, a venture capital firm like Andreessen Horowitz can invest $100 million in a start-up valued at $1 billion, knowing that the value would have to drop below $100 million for the venture firm to lose money.

In real life, things are more complicated. With any start-up, there are probably multiple venture investors, who will collectively put up, say, $300 million in a start-up with a billion-dollar valuation. Still, the point is that the valuation would have to fall markedly for a firm like Andreessen Horowitz to lose money.

This “insurance” gives Silicon Valley an incentive to inflate valuations. Let’s say you are a lucky founder of a start-up that you think is worth $800 million. 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.

The venture capital firm accepts, and you can trumpet to the world that you are now a member of the vaunted unicorn club, with all the publicity that comes with it. And that may be one big reason valuations in Silicon Valley are so disconnected from the public markets.

There is evidence that this is the Silicon Valley game of the moment. CB Insights has compiled a list of all unicorns. If you take all the unicorns so far in 2015 — 59 of them — the median valuation after the latest investment is $1.1 billion. The Fenwick & West survey found similar numbers. Coincidence?

That protection, however, may not just be driving up valuations. Liquidation preferences can come back to bite a start-up’s founders if valuations come down.

Higher valuations create higher expectations, and failure to meet them can set off a downward spiral and a forced sale. In that event, the venture capitalists are paid first, leaving “unicorpses” in their wake and the founders with nothing.

The recent season of the HBO comedy series “Silicon Valley” portrayed just such a situation: A founder of a dead start-up received nothing in a sale as a result of a liquidation preference, and was left crying that he “could have taken less money.”

But liquidation preferences can really hurt some entrepreneurs who have agreed to them in exchange for an investment that results in a lofty valuation.

According to PitchBook, the Series B investors in Honest Company, a start-up founded by the actress Jessica Alba that sells nontoxic household and baby products, have a two times liquidation preference on their $50 million investment. This means that in a sale, they will be paid not just $50 million, but double that, or $100 million, before Ms. Alba can receive a cent.

Defenders argue that valuations are so high — Honest Company was valued at $1.7 billion in its latest round — that there is sufficient room for a sharp discount before founders get hurt. Fenwick’s survey notes that CB Insights says that the 10 biggest unicorns are valued at $122 billion with a total investment of only $12 billion — meaning there is a lot of room to come down.

We’ll have to see how this works out, though you can be sure that there will be founders who will come to rue the day that they didn’t look at the terms of their investment more carefully.

A recent paper by Prof. Robert Bartlett, my colleague at the University of California Berkeley School of Law, actually does the math. A liquidation preference similar to Honest Company’s can bolster the returns of the V.C. investors by as much as 10 times. All at the expense of the founders.

And don’t expect I.P.O.s to save these companies. 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.

Conversely, the liquidation preference may also not give venture capital investors all the protection they may think they have.

A number of founders have followed the Mark Zuckerberg route and kept control of their companies. According to Fenwick, 22 percent of companies in their sample have dual-class stock, which typically gives total control over the company to the founders and first investors. Most other companies also give control to the founders through simple majority voting provisions that allow the founders to vote their common stock together on a one-to-one basis with the preferred stock.

In these cases, if a situation arises where the founders will not be paid because of the liquidation preference, expect a war: The founders may very well refuse to approve a sale, and such a battle will probably only get resolved in the courts.

As these valuations go up and down, remember that reaching a $1 billion valuation is not all good news for a start-up. Instead, it can simply mean that the newly foaled unicorn has made a Faustian bargain.