A Founder's Guide to Unicorn Creation: How Liquidation Preferences in M&A Transactions Affect Start-Up Valuation

Abstract

This chapter, written for a Research Handbook on Mergers and Acquisitions (Davidoff-Solomon & Hill, eds.), investigates the widespread claim that the billion dollar valuations of “unicorn” start-ups are unreliable because of the manner in which founders bargain for these valuations with their venture capital (VC) investors. In particular, unicorn skeptics posit that VC investors agree to use these valuations in exchange for receiving enhanced preferred stock preferences, particularly enhanced liquidation preferences that are payable on a sale of the company.

By examining how liquidation preferences affect expected returns of founders and VC investors, this chapter argues that unicorn valuations are indeed unreliable measures of firm value but not for the reasons suggested by unicorn skeptics. While offering enhanced liquidation preferences to an investor can overcome the reduction in expected returns caused by financing a firm at a higher valuation, doing so will generally be more detrimental to a founder’s expected returns than financing the company at a lower valuation using a conventional liquidation preference. Rather, this chapter argues that unicorn valuations are unreliable measures for firm value for the same reason that all start-up valuations are unreliable measures of firm value — namely, the common practice among VC investors to price VC financings as if they are purchasing common stock when they are acquiring preferred stock with downside economic protections. As a result of this practice, the reported valuations of unicorns and non-unicorns alike can be significantly higher than the enterprise value an investor is implicitly placing on a firm when financing it. For founders and prior stockholders, this insight has important implications for understanding the effective enterprise value being used in a financing and avoiding unintended dilution.

Keywords: venture capital, start-ups, valuation, preferred stock

JEL Classification: G32, G34, K22