When dollars grow on trees
Who has the opportunity to see the award-winning comedy series HBO Silicon Valley, broadcast on Sky Atlantic, do it. It's not just funny, but also tremendously instructive: shows us one split important gods times modern, like Charlie Chaplin's masterpiece of the same name. The series tells the story of pied pipera startup creator of a revolutionary compression software, which operates in the famous valley between San Francisco and San José, the valley where at the time of John Steinbeck on trees plums grew and today dollars grow. Dollar trees feed the unicorns, a new type of beast that has its ideal habitat in this strip of land. Now there are more than 80 specimens. The unicorns are there startup with a capitalization higher than billion dollars. A lot of these unicorns have revenues almost inexistent and therefore, apparently, it is not clear how they can get all this money from investors.
All projects basis of this phenomenon, which has exploded in recent years, there is the easy money launched from helicopters Federal Reserve in the gardens of financial institutions, a phenomenon known as quantitative easing (QE) which, for one reason or another, continues to linger in the US and Europe. Unlike the FED, however, the Investors they don't drop money from helicopters, but are very notice in not wasting capital. Therefore they have invented of the protection mechanisms which can become real traps for unicorns if their business doesn't go as it should.
The hunger for capital of innovative startups
We know very well that the startup have need di capital and that these capitals can only be risk. A innovative startup it's a car money eaters: before three years it is difficult to see something that can be spent on the market. We also know that i CHILDREN got out ofuniversity, the main basin of talents of startups, their heads are teeming with ideas, but theirs Bank account is often in red, especially in the United States. Why these ideas can find theirs execution have need of the capital of people and institutions ready to to risk heavily.
It then happens that the Investors – called in many ways, prestigious (angels) and derogatory (vultures) – look at these startups as risky bets and therefore have invented many protection mechanisms of the invested capital. It's about mechanisms rather check and they work well in their favor, even if they do not eliminate the risk entirely.
Over 90% of startup fails to carry on the project and therefore the failure it's a'option so likely that it has become part integral of entrepreneurial culture of the valley where the “fail fast, fail often” is on the business card of every successful entrepreneur. “Failure builds character” was a favorite narrative of Steve Jobs who spoke of his ouster from Apple in this way: “the best thing that happened to me”.
Privileged liquidation
Then there is the preferential liquidationa clause contractual guarantee which acts in the case that the business not working as expected and should be liquidated. It is not a burdensome and annoying condition like the surety of our banking system, which affects the entrepreneur's family and personal assets, but it is certainly something that penalizes i founders and it can them too mess up, even if it does not act directly on their personal assets.
In the unfortunate event of cession of startup or one of his own asset, preferential liquidation works in a very simple way: i proceeds of the sale, probably well below the valuation of the startup at the time of purchase of the stake but sufficient to cover the VC capital, will be transferred immediately to Investors of VC up to cover up the value of theirs investment. Who will bring the heavier weight of this situation will be precisely the founders who will go to divide il residual capital, if it still exists and generally doesn't exist after paying off the VC. In the aforementioned HBO television series Silicon Valley at the end of the second season, the "preferred liquidation" takes place to the detriment of the nerd founder of Pied Piper, Richard Hendricks, who is excluded from the startup he founded.
Steven Davidoff Solomon, professor of law at the University of California Berkeley, explained very well the preferential liquidation and its consequences in an article in the “New York Times” which we offer to the reader of ebookextra in the translation of John Akwood.
VC investment is not a gift
Inside the unicorns of Silicon Valley hides a time bomb. It's something inherent al VC is pump money in startup innovative and that later can lead those same startups atself destruction. With all the fuss and debate surrounding astronomical startup valuations, it's good not to forget that the mechanism that turns on these hypervaluations can also be turned off.
The "bomb”, so to speak, is known as preferential liquidation. In each new funding round, theinvestment of a company of VC not it's a gift. The VC and the startup go to make arrangements on some condizioni di protection ofinvestment.
The negotiation discusses voting rights, seats on the board of directors of the startup and the guarantees so that a subsequent contribution of third-party capital does not dilute the shareholding of the VC company.
La preferential settlement is the most very important of these forms of protection of the investment. It is a clause which provides for the priority refund of the investment of VC company that must have the priority on that of the founders and employees. If the company of VC sees a particular negotiating leverage, can to deal anchor more advantageous clause known as senior preferred liquidation. This clause provides that the VC company will be paid not only before purchasing, of ordinary shareholders, but also before any other investor with preference shares acquired in previous rounds
These provisions si apply in case of sale ma not in the case of OPA (initial public offering of shares). The idea is to guarantee the investor the return of the initial capital even if the business goes badly. According to one recent investigation of the law firm Fenwick & West conducted on 37 unicorns – private companies with a valuation exceeding one billion dollars – all they have one clause di preferential liquidation.
The need for overestimation
Let's reflect for a moment. In the public stock markets there is not no guarantee on return of the invested capital. But in the Silicon Valley you can get one warranty that you ensure revenues in case of sale, undoubtedly higher than what investors could obtain in other areas. It's a good deal e explains largely because VC firms are on their own ease with the overestimates.
Una warranty such as preferential liquidation tends a to push even more up these assessments. For example, a VC firm like Andreessen Horowitz may invest more than $100 million in a startup valued at $100 billion, knowing that to lose any money, the startup's value must fall below $XNUMX million.
In real life, though, things are more complicated. In each startup there probably is more than an investor by VC. Let's say we collectively invested $300 million to raise the valuation to $XNUMX billion. Despite this crowding of VCs, the evaluation of startup should go down a lot because Andreessen Horowitz can lose money.
That's why this "."Is a incentive a inflate le assessments. Let's say there's a lucky startup founder who values his business at $800 million. Thanks to the preferential liquidation clause he can ask the VC for a valuation of a billion dollars with the argument that the preferential liquidation will protect him from a possible downside. The VC firm accepts, and the young entrepreneur can trumpet to the world that his startup is a new member of the unicorn club, with all the hype that goes with it.
This case, which occurs frequently in the valley, can explain the main reason why the Silicon Valley look like un world apart, a market disconnected from other markets. This is currently the hottest game in the valley. CB Insights has compiled a list of all unicorns. Well, the median rating of all unicorns, after the ulast round from ininvestment, and of 1,1 billion of dollars. The Fenwick & West investigation found similar numbers. Coincidence?
The one corpses
This protection, however, once in place it doesn't help to raise the capitalization. Rather, preferential liquidation can backfire against i founders if the evaluation of the business goes down.
Higher and higher ratings always create higher expectations and the fact of disappoint them can trigger a downward spiral up to one forced sale. In this case, the VC gets paid first, leaving several "ones" in their wake, inclusive founders that remain empty hands.
The final season of the HBO comedy series Silicon Valley it ended just like this: the founder of a bankrupt start-up received nothing from the sale as a result of the privileged liquidation which left him in tears at the thought that “he should have taken less money”.
In fact the preferential liquidations they really can damage The entrepreneurs who have shown themselves ready to accept them in exchange for an investment based on a inflated rating.
Honesty Company, a startup founded by actress Jessica Alba that sells nontoxic household and baby products, has a privileged double liquidation on an investment of 50 million. This means that in the event of a sale, Jessica Alba will have to pay 100 million before seeing a cent.
Overvaluation also protects founders
I defenders they argue that with such high ratings – Honest Company was valued at 1,7 billion dollars in the latest investment round – there is enough space for a substantial discount before i founders are damaged. Fenwick's investigation shows that i 10 biggest unicorns are evaluated overall 122 billion dollars in front of a VC di 12 billion, meaning that there is a lot of space for the fall.
We'll see how it ends. In any case, there will be some founders who will regret not having weighed more carefully the conditions of the investment.
In a recent document Professor Robert Bartlett, a law school colleague of mine at the University of California Berkeley, did the math. A preferred liquidation clause, similar to that of Honest Company, can inflate the investor's return by up to 10 times. All at the founder's expense.
Nor is it to be expected that a takeover bid will save the unicorns and their founders. Some unicorns, like Honest Company, have bargained with the VC a minimum quotation price in the case of a takeover bid that is totally unrealistic in the short term. According to Fenwick & West, the 19% of unicorns ha this clause of the minimum quotation price.
The countermeasures of the founders
Preferred liquidation can do not provide al VC the whole protection which he thinks he has. A good number of founders of startups have following the footsteps of Mark Zuckerberg for to maintain il control of theirs company. According to Fenwick, the 22% of the sampled startups have a system with voting shares and non-voting shares (dual-class stocks) which, as is known, ensures control of a company to the minority shareholding of the founder or founders.
With the dual-class stock system active, i founders, if if one occurs situation in which not are paid due to the preferential settlement clause, they can not approve la sale and unleash a war that can be resolved solo in court.
Since startup valuations are like roller coasters, it should be remembered that one valuation of one billion dollars not it is always one good news. On the other hand, one may think that the newborn unicorn has tightened a Faustian pact.
