What does it mean that "Late-stage private valuations" aren’t really equity, but more like debt?

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JASON LEMKIN

I think it’s a bit of an exaggeration, but the point is a lot of these late-stage stock rounds have one or more characteristics of debt:

  • They come “before” other equity, i.e., they get their money out first, sometimes even multiple times (Sam’s 2x “liquidation preference” example).  In a sale or even a bankruptcy, debt gets their money out (usually) before anyone with stock / equity gets a nickel.  This allows debt to be issued for a “cheaper” price than equity, because they have this at least partial downside protection.  These late stage rounds feel like they have similar protection, as long as the company is sold for more than the amount invested in the last round.
  • They have a guaranteed return, like a coupon or interest in debt. Having a 2x liquidation preference, or a 20% IRR “guarantee” going into an IPO, is sort of debt-like in that a minimum return is guaranteed at least in a number of scenarios.
  • Ratchets are somewhat like convertible bonds and debt.  I.e., as a late-stage investor, I get the “guaranteed” best price in an IPO (or even after), and if the IPO does better than that, then I also get to keep all the upside.

The fact that there is both real and perceived downside protection, and in some cases, a semi or at least pseudo-guaranteed return … enables investors to pay a higher “cover” price for the stock than someone just buying common stock with zero protections and hoping the equity does “all the work”.

No employees or founders get these downside protections, that seemingly guarantee at least modest returns, and realistically, no early stage investors get them, either.

Having said that …

In many cases, these protections and “debt-like” provisions don’t really work like debt.  Many are extinguished in an IPO.  Some can be renegotiated (with a lot of drama) in M&A, or at least, gamed.  At a practical level, M&A at 1x the amount of the last round can and does happen … but often those deals are so messed up, they don’t really happen, b/c what founders and early investors are gonna sell and keep $0 for themselves and let the guys that invested most recently take 100% of the proceeds?  And if the company goes under, these provisions are pretty much worthless.

I think the idea that a liquidation preference is hugely “protectful” is a bit optimistic.

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Published on November 3, 2015
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