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Liquidation Preference - Yesterday again tomorrow? - Hedge Accordingly

For close to 24 months now every financial media houses have managed to make unicorn a household name. With private investors getting into these rounds, theeconomics of traditional venture capital has been flipped (without many realising it). As I argue further in the postabouttheprevalenceand unspoken arithmetic of liquidation preference. The profile of thelate-stageinvestors has largely been driven by mutual fund investors, private equity and hedge funds - the kind of capital which I would call asflight foreignfinancing, which would exit at the first sign of danger. Such capital I wager should be carefully dealt by the traditional venture investors for their own good.

Liquidation preference is well-known concept by now and is often cited as a downside protection for late-stage investors. Whilemostarticles I have read and people Ihaveread talk about liquidation preference most of them have focussed on the very obvious (first level thinking) details. Lets make an attempt to dive a tad deeper into how thearithmeticwould work -

Remarkably little attention has been given to the viability of liquidation preference.To put in otherwise, if founder does manage to convnice late-stage investors to fund the company at a higher valuation using special liquidation preferences, would it affect the returns of existing investors? It's no rocket science that offering additional liquidation preference can induce investors into participating into the round, the comensurate amount of liq preference would put pressure of the expected (percieved) returns of the existing investors and founder. In conventional theory, one would price companies based of the pre-money and dilution offered. However, with the added downside benefits of the liquidation preference would mean that obtaining expected similar returns would require the investor to invest in the firm at the lower valuation than the one nominally placed. Invariably, what you see is an inflated price of the company without knowing the stack of liquidation preference.

Lets assume a fictional company called ABC Corp raises two standard rounds of VC financing. The first round had the company selling $50mn of conv preferred stock at $1/share to X Fund. During the round. the only outstanding securities of ABC Corp were 200 mn shares of commonstockheld by founders. Based on their diligence X fund decided to value ABC Corp at $200mn such that they purchased 50mn shares of newly issued preferred stock at $1/share. We assume for simplicity sakethat the current round included a vanilla 1x liquidation preference.

Moving ahead lets assume that ABC Corp is not able to achieve a few product/biz milestones as is nowmanagedtoattractedanother VC investor - Y Capital who agreed to value ABC Corp at $500mn which would purchase $75mn of newly issued Series B Preferred Stock. Y Capital paid a $2/share for the 37.5mn of Series B Preferred Stock. Similar to that of Series A financing, the current round includes a 1x liquidation preference. Also, it was agreed between X Capitaland Y capital that in a situation wheresufficientfunds are not able to pay the liquidation preference in full, it would be paid on a pro-rata basis.

Post the latest round offinancing, X Capital would convert into common stock only in an acquisition/liquidation event where distributableproceedsof atleast $325mn whereas for Y Capital only anacquisition/liquidation event wheredistributableproceeds of more than $525mn wouldinduce it to convert its Series B Preferred stock to common stock.Thus, the common use of liq preferences and staged financing ultimately creates the possibility for a significant conflict among a companys investors regarding an acceptable exit price for the company.

Bar-mistzvah moment

Now consider an event where the ABC Corp has managed to deliver exceedingly well and manages to catch the attention to Z Capital (a late stage hedge fund). Z Capitals team is fairly confident that ABC Corp would be an acquisitiontargetlargely because of itsproprietarytechnology and its unique customer base andthus decides to invest $100mn in the it at apre-money valuation of $746 mn. As to how Z Capital arrived at $746 mn, you would know shortly. Z Capitals team comes upwith the following table attaching a 10%probabilityof ABC Corp getting acquired considering multiple values -

Z Capital using the conventional discounting approach of 30% (hurdle rate), the rate which would be used to arrive at the expected pre-money financing value at $746 mn. The founder of ABC Corp ishoweverinsistent ofreachinga billion dollar valuation which would allow it to attract quality talent and also for existing investors to sound savvy in cocktail parties. The founderthusproposes a pre-money of $900mn (post money of $1bn YAY). Bases of arithmetic probability, Z Capital comes up with the following -

As this table suggests, if Z Capital agrees to a $900mn pre-moneyfinancingits return on capital would come down to 28.29%largelybecauseZ Capital $100mn investment would entitle it only to 10% of ABC Corps capitalisationwhereas, at a $747 mn pre-money, Z Capital wouldreceive12% of the equity. The founder now has to be able to attract Z Capital withsignificantlyhigher returns forarrivingat the $900mn pre-money which would lead him toenchanced liquidation preference. Using multiple scenarios - we come up with -

Contrary to widespread speculation, senior liquidation preference stack for Z Capital wouldhavenegligibleeffect on Z Capitals expected returns at a $900mn pre-money. In contrast, increasing the liquidation preference from 1x to 2x has a drastic impact on Z Capitals expected returns to 92.3%.Byreceivinga 2x liquidation preference, Z Capital would be assured of a 100% return of its investment for anyacquisitionvaluing ABC Corp above $325mn resulting in significant improvement in expected returns.

We clearly see how attempts to increase liquidation preference would make a dent on the returns of existing common stock holders. Investors thus have to at large be wary of inbuilt protections, within the rounds that have a bearing on their own investmentreturns.

Not sure if this is right but this could be a reason why a select few accelerators have raised HUGE growth stage funds (realising that they are getting crushed by late stage investors). Detail in this instance lies in the detail.

(Source - Media articles, Google, blog posts)

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