Preferred Stock Protections in Unicorn Investments Might Be Less Valuable Than Expected

I’ve previously written about the importance of considering the terms of a unicorn financing, and not just the valuation, in evaluating the overall economics of the financing.

As part of such analysis the importance of “downside protection” terms like liquidation preference (which provide investors the right to receive their investment back first in an acquisition of the company) and IPO anti dilution protection (which provide investors with additional shares if the IPO price is below the price the investor paid) has been discussed. It was noted that because of these provisions, in many cases the valuations of unicorns could fall by 90% and investors wouldn’t lose money on their investment.

However there is a catch. And it could be an important one that could come to haunt investors. The catch is “pay to play” provisions.

Pay to play provisions are used by companies when the company or the venture economy isn’t doing well. These provisions provide that if the company needs more money, and can’t raise the money on reasonable terms from new investors, then the company’s current investors are expected to each invest their pro rata amount of the needed funds into the company. So for example if a unicorn needs an additional $50 million to stay afloat during tough times, and the investor owns 10% of the company, the investor is expected to invest an additional $5 million. And if the investor doesnt make that additional investment, its preferred stock, which is the stock that has the special downside protections and other rights that they negotiated for, gets converted to common stock, and they lose those special rights.

This happened fairly frequently after the dot-com bubble burst in the early 2000s, and would probably happen again if current unicorn valuations declined significantly, especially if that happened in conjunction with an overall decline in stock markets and the economy in general.

Non-traditional investors, such as mutual funds, hedge funds, special purpose vehicles (funds that are created to make a single specific venture investment) and corporate investors, may need to be especially wary of this scenario. The reason is that these investors are structured differently than venture funds.

Venture funds are built for the cycles of the venture environment. The funds have 10–12 year terms and investors are not allowed to withdraw their investment from the fund before the end of the term. And when venture capitalists invest in a company, they generally assume that they will need to make additional investments in the company in the future, and reserve a portion of their fund to make those additional investments.

Many non traditional investors are structured differently, with investors entitled to withdraw their money from the funds on relatively short notice — usually days in the case of mutual funds and months in the case of many hedge funds — which could make it difficult for these funds to make further investments if investors are withdrawing money from their fund. Special purpose funds often have no easy way to go back to the investors who provided them the money for the initial investment and require that they provide additional funds to meet a pay to play obligation. And corporate venture funds can be subject to the current business fortunes of the parent company in making decisions to invest additional amounts.

When the economy is stable all this usually isn’t a problem. But if the economy becomes very rocky with significant stock market declines, these non-traditional funds may find their investors seeking liquidity, to meet other obligations or to reduce their risk exposure. Accordingly the funds may find themselves without the ability to make additional investments to meet their “pay to play” obligations.

As a result, the downside protections that they thought would protect them in a downturn may be lost, and the loss in the value of their investment as a result of the downturn might be much greater than they had anticipated.

Now to be clear, the concerns raised here do not apply to all non-traditional investors, for example some have invested only small portions of their funds in illiquid investments and could obtain needed funds from the sale of their liquid investments, albeit in a down market where they might need to sell at depressed prices.

And importantly, venture capital investors who did not reserve sufficient funds or who don’t want to invest further in the unicorn might find themselves subject to the same problems.

In fact, it is very possible that venture capitalists could find they have under reserved for these pay to play investments. Because while venture capitalists are familiar with the dynamics of the venture cycle, they may not have prepared for a cycle like this where company burn rates have become so high, and accordingly the amount of money that companies might need to raise in a downturn might be higher than expected. And those venture capitalists who invested early in unicorns at low valuations might find that the downside of their high ownership percentage is that their pay to play percentage is also high.

So the take-away here is that venture investing through a full economic cycle is dynamic and complex, and it’s necessary to prepare for a rainy day. And the best preparation for a rainy day is to assure that the company has large cash reserves and the ability to reduce its burn rate, so that it doesnt need to raise money during difficult times, and that investors have sufficient cash reserves to protect their investment if the company does need to raise money.

It hasnt started raining yet, and it may not rain at all, but smart companies and investors should be thinking about whether they are prepared for a rainy season. Maybe it’s just a coincidence, but a heavy El Nino storm system is predicted for Silicon Valley this winter.