When startups begin to negotiate for venture financing, most are primarily focused on maximizing their valuations. While founders are wise to focus on the valuation term given its importance to the company’s public perception and financial position, that focus may ultimately be leading founders to undermine their own interests.
When venture capitalists (VCs) invest in companies, they purchase preferred stock, which provides shareholders with certain rights not available to holders of common stock. ((See Steven Davidoff Solomon, The Risk of a Billion-Dollar Valuation in Silicon Valley, N.Y. Times: Dealbook (Sept. 22, 2015), http://www.nytimes.com/2015/09/23/business/dealbook/the-risk-of-a-billion-dollar-valuation-in-silicon-valley.html?_r=0.)) Among these additional rights is liquidation preference, which ensures that, upon the occurrence of a liquidity event (i.e. sale of the company), VCs are paid in full before any proceeds are passed along to founders and other shareholders. ((Id.)) This provides VCs with fairly strong investment protection. For instance, suppose a VC invests $50,000 for 10% of a company’s shares (thereby creating a $500,000 valuation) with liquidation preference rights. If the company underperforms and is subsequently sold off for a mere $50,000, all the proceeds of the sale will pass along to the VC who will recoup the entirety of his initial investment. Meanwhile, founders who may have made substantial personal investments into the company, will receive nothing.
Though that arrangement might not sit well with founders, some may be inclined to agree to it where it can assist in bargaining for a higher valuation. ((Id.)) However, accepting such a tradeoff may actually exacerbate the risks associated with liquidation preference. As liquidation preference provides VCs with the opportunity to recoup their investments even in the event of massive valuation loss, they see minimal risk in inflating a portfolio company’s valuation. From a founder’s perspective, it may be difficult to pass up on the opportunity to attain a higher-than-anticipated valuation even if it seems unlikely that the company could feasibly sustain that valuation. This phenomenon was captured in a recent episode of the popular HBO show Silicon Valley, where a founder forced to sell off his underperforming company lamented that his plight could have been avoided if he’d simply “taken less money” from VCs. ((Id.))
Though a dramatic (and fictional) example, this scene is illustrative of a troubling trend in venture financings. The number of private companies receiving billion-dollar valuations, referred to as “unicorns”, has ballooned in recent years. Perhaps more troublingly, startups are seeing dramatic increases in their valuations from one year to the next. ((Evelyn M. Rusli, Startup Values Set Records, Wall St. J. (Dec. 29, 2014, 7:50 PM), http://www.wsj.com/articles/tech-startup-values-reach-the-sky-1419900636.)) Uber, for example, received a $41.2 billion dollar valuation in 2014 despite being valued at roughly 1/12th of that total in 2013. ((Id.))
Though it’s easy to understand why founders would accept these valuations, why are investors allowing valuations to grow at such a dangerous rate? The answer may lie in liquidation preference. According to a survey by the Silicon Valley law firm Fenwick & West examining venture deals for 37 unicorns, VCs received liquidation preference in each deal. ((Solomon, supra note 1.)) With their investments insured in this way, VCs may be more cavalier in setting valuations since the risk of a bad valuation falls primarily on the shoulders of the company’s founders. For founders, a billion-dollar valuation may seem like a deal that is too good to refuse, but it can result in exactly the situation depicted in Silicon Valley. With an unreasonably high valuation comes unreasonably high expectations. When the company inevitably fails to meet those expectations, founders may lose everything and be forced to sell off their companies at a fraction of its original value. ((Id.))
Though some may be inclined to trust that VCs wouldn’t set startups up for failure in this way, founders should beware of the perverse effects of liquidation preference. With their investments insured and with little to lose by giving in to founders clamoring for higher valuations, VCs may be systematically leading startups down a path of failure.
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