Heads We Win, Tails They Lose:
How Venture Capital Investment Structures Preserve Value for Investors
By Rick Nathan, Senior Managing Director
The first half of 2022 saw a huge drop in public market valuations across the technology sector. Some of the hardest hit names have included the large cohort of newly public 2021 IPOs, most recently celebrated as successful exits from private venture capital portfolios. While many of these companies have seen their stock market values decline by 50% or more, their recent peers that remain private have generally not seen similar markdowns in their private portfolios. Many observers suggest that VC’s maintain inflated values artificially or do not ‘mark-to-market’, choosing to avoid their inevitable portfolio declines, but that is generally not the case¹. Investors in these private VC funds should understand how these valuations are preserved.
Venture capital firms are expert investors in high-risk emerging technology companies and can only succeed if they learn how to manage those risks effectively. One of their most important risk management tools to preserve the value of their capital lies in their investment structures, and in particular, the use of preferred shares. While there are many variations, the core structural elements all follow the same theme: when values rise, the investor fully participates in the gain; but when values decline, investor capital is protected.
Let’s take a look at a simple example of a preferred share financing. ABC Corp. raises $25 million in new capital at a valuation of $100 million (post), so the new investor holds 25% of the company. For simplicity, we will assume that ABC had previously issued only common shares, and the new investor bought standard preferred shares, convertible for an equal number of common shares at the investor’s option. Absent conversion, the preferred shares are entitled to recover their face value upon a sale of the company.
Heads We Win
The upside case shows the outcome when the valuation rises. One year following the investment, ABC gets sold to an acquiror who pays $200 million for the entire company. Our investor holds 25% ownership, and receives proceeds of $50 million after converting the preferred shares to common shares to complete the sale transaction. The total company value doubled and the investor’s shares correspondingly doubled in value. The investor wins alongside the other shareholders when the company succeeds. Simple enough.
Tails They Lose
The downside case is more interesting. Instead of the example above, let’s say that ABC declines in value and gets sold for just $50 million. The total value of the company has dropped by half. In this scenario, the investor chooses not to convert into common shares, and sells their preferred shares for their $25 million face value (known as their ‘liquidation preference’). The total proceeds from the sale of ABC get allocated much differently: the investor receives their full $25 million while all of the remaining ABC shareholders divide up the remaining balance. When the value of the company drops, the investor’s capital is preserved while the prior common shareholders suffer the entire loss.
In order for our preferred share investor to lose capital, the total proceeds from the sale of ABC Corp. must drop below the liquidation preference. If the company is sold for proceeds of $30 million, our investor still recovers the first $25 million off the top, while the common shareholders suffer the loss and divide up the remaining $5 million. It is only when the total proceeds drop to, say, $20 million, that the preferred shareholder takes a hit, since there is not enough money to fully repay them. In that case, the preferred shares receive 100% of the proceeds below their liquidation preference amount while the common shareholders are left with nothing.
These preferred share structures explain why many of the high-flying valuations of 2021 are preserving their values per share, even after many of the corresponding total company values have declined dramatically. These preferred shares typically retain 100% of their initial value so long as the total company value remains greater than their liquidation preference amount. Our example investor can continue to mark-to-market the value of their ABC preferred shares as being equal to their cost after the total enterprise value of ABC Corp. has declined significantly, so long as that total enterprise value remains above their $25 million liquidation preference.
Real World Complexity: Navigating the Preferred Share ‘Stack’
Most venture-backed companies raise financing through a series of new rounds of preferred shares issued over time, typically designated by lettered names: Series A, Series B and so on. Traditionally, the first issued preferred shares will be Series A, and when a new investor buys in later in a subsequent financing round, the company will issue Series B shares, which will be ‘senior’ to the Series A and rank ahead of them on a payout. Sometimes the preferred shares will accrue dividends so that the liquidation preference amount increases over time. It is normal to see share capitalization tables in venture-backed companies develop into a complex layered structure, known as the ‘preferred share stack’, with each new round of investors ranking ahead of their predecessors. The details of these share structures can vary significantly, limited only by the imaginations of the negotiators.
But the core valuation principles that support the preservation of investor capital remain in place across the vast majority of financings in the private venture capital market. The new money invested gets paid out first, preserving the value of investor capital, before any payments are made on the more junior shares. These structures act as important shock absorbers to enable investors to manage risk and reduce volatility, preserving their invested capital when the total value of their portfolio company declines.
¹ Most VCs revalue quarterly for slightly delayed mark-to-market reporting relative to the public markets.