Do liquidation preferences drive up valuations?

A recent New York Times DealBook article by “Deal Professor” Steven Davidoff Solomon refers to the fact that all 37 “unicorns” referenced in a recent survey by Fenwick & West had a liquidation preference, and claimed that “such a guarantee very likely pushes valuations even higher.”

First of all, it’s quite a stretch to say that liquidation preferences in effect “guarantee” some level of minimum proceeds in an exit. A liquidation preference is just a preference over junior classes and series of stock in a liquidation scenario. The investment could still fail to produce expected returns, or any returns at all.

Secondly, liquidation preferences have been around forever in VC deals. It is certainly not a novel or revolutionary feature of private company financings.

Finally, according to  a report by Wilson Sonsini Goodrich & Rosati, almost all private company financing deals contain liquidation preferences, whether the company is a unicorn or not. So the liquidation preference is a feature not at all limited to unicorns’ financings.

I’ll admit, that yes, given the downside protection, liquidation preferences likely do give investors assurances that they will be able to recoup their investment upon a favorable exit, and therefore investors have more comfort in agreeing to what otherwise would be considered an inflated valuation.

However, I’m very doubtful that the liquidation preference feature of unicorns’ financing terms, by itself, is any reason for the inflated valuations we’ve been seeing lately. It’s certainly not a guarantee, it’s certainly not new, and it’s certainly not limited to unicorns.

So what could be the cause of unicorns’ inflated valuations?

I mentioned in a previous post my belief that a combination of the following (in the following order of likely impact) is to blame for the unicorn explosion: (a) sub-zero interest rates, (b) low oil prices, (c) uncertainty in European and emerging markets and (d) volatility in the public capital markets.

Simply put, gambling on unicorns may just be the best (only?) place for institutional investors to put their clients’ money.

If it’s anything like representing technology startups, investing in technology startups is also probably a lot more fun.

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