Liquidation Preference and Participation Caps for Unicorns

I read an article over the weekend talking about Unicorns and their respective valuations: http://recode.net/2015/05/10/heres-one-thing-all-the-billion-dollar-unicorns-have-in-common/ — The author stated that the thing ALL Unicorns have in common is that they have Liquidation Preferences (ie, the investors have the ability to take out their full investment BEFORE any of the common shareholders including founders and management).

It’s probably worth noting but not exactly earth shattering — here’s an insight about venture backed deals — they ALL have liquidation preferences. Here’s Fred Wilson’s blog post explaining why: http://avc.com/2010/08/heres-why-you-need-a-liquidation-preference/

The more interesting discussion would have been around whether or not the late stage investors had multiple liquidation preferences or participating preferences. What are liquidation preferences and/or participating preferences?

Quick primer:

LIQUIDATION PREFERENCE — typically 1x (particularly for early stage investors because they don’t want to set a precedent for any other liquidation preferences — more on that in a future post). However, in weird times, they can vary, from 2x to as high as 10x (in the late 90's and early 2000's). What does that exactly mean? Let’s say a late stage hedge fund invests $50MM in Unicorn.io at a $950MM pre-money valuation. Let’s assume there are two scenarios —

• In Scenario A, Late Stage fund invests at 1x liquidation preference and the Unicorn.io sells for $2B. The fund can then convert to common (assuming no additional financings and no further dilution) and get gross proceeds of $100MM OR they can stay as the 1x preferred and get back $50MM. They would convert to common and get back the $100MM.
• In Scenario B, Late Stage fund invests at 3x liquidation preference and Unicorn.io sells for $2B. The fund can convert to common and get gross proceeds of $100MM or they can stay as the 3x preferred and get back $150MM. In this instance, they would NOT convert to common and instead get back $150MM.

PARTICIPATING PREFERENCE — typically non-participating. However, participating preferred terms can arise when there is a valuation gap between investor and management. Let’s again bring up Unicorn.io. Let’s assume late stage fund invests $50MM at a $950MM pre-money valuation.

• In Scenario A, Late Stage fund invests with a 1x liquidation preference non-participating and Unicorn.io sells for a $2B. The fund can convert to common and get gross proceeds of $100MM or they can stay as the 1x preferred and get back $50MM. They would convert to common and get back the $100MM
• In Scenario B, Late Stage fund invests at a 1x liquidation preference with participation up to 3x and Unicorn.io sells for $2B. The fund can convert to common and get gross proceeds of $100MM or they can exercise their participating preference up to 3x which means: fund first takes their $50MM back (leaving proceeds of $1,950,000,000). Then takes 5% of the remaining proceeds ($97,500,000) which yields total gross proceeds of $147,500,000. Any exit greater than $3B yields an outcome where the hedge fund would convert to common (because of the 3x cap). If Unicorn.io sold for $3B then Late Stage fund would convert and receive $150MM in proceeds, which is the same as them NOT converting (as their return would be capped at 3x).

If the article pointed out that the late stage guys had terms like this on Unicorns— 2x liquidation preference with a 4x cap (ie the late stage guys pull out double their money and then participate in the remaining proceeds until they achieve a 4x return), THAT would have been interesting (and maybe not surprising).