An explanation of the magic behind shareholder’s agreements and startup valuation.

1 - Not so crazy after all...

Since the first half of 2022, we have seen the market tank precipitously, with no end (yet) in sight.

Data from Pitchbook suggests that in Q2’2022, global VC funds recorded a -2.3% rolling one-year IRR (incorporating both cash return and changes in NAV). It is the first time that one-year VC returns have fallen below zero since 2016.

The individual numbers are even more staggering, with firms like Tiger Global ($43Bn marked down this year) and Softbank ($23Bn marked down in Q2 only) recording tremendous losses.

Again, calculated on the NAV not only on DPI (cash return).

Conveniently, these are some of the same investors that contributed to the eye- watering valuations of 2021.

In that Newletters we will try to explain how those investors manage to price huge valuations while protecting themselves on a downside scenario at the expense of other investors

At the end, you will probably stop saying « Venture valuation doesn’t make any sense ! ».

2 - What happened, and what are the implications for startup valuation moving forward?

2021 featured unprecedented allocations toward venture capital as cheap money abounded. With a perceived absence of risk, some investors may not have given credence to each of the clauses and agreements that are typically attached to private shares.

As investors sift through the wreckage seeking to understand the intricacies of each exposure, they are forced to come to terms with one of the most complex aspects of VC investing: the cash flow waterfall.

In this newsletter we will break down the components of a typical cash flow waterfall, and the elements of valuation that are typically involved therein.

3 - Preferred Shares vs Common Shares?

There are two types of equity: Common and Preferred. Preferred shareholders have a more senior claim on asset distribution than common shareholders. The stipulations on each class of preferred shares depend on the terms of the issuance (which are typically negotiated between the VC fund and the company).

Preferred Stock aims to protect the investors on a potential downside scenario - That is why when seeing huge valuation, those valuation are calculated for preference shares.

The more rounds (Series A, B, C) a company have, the more classes of shares it will have created.

As investors and founders negotiate varying terms across each investment round, the aggregate sum of conditions can reach enormous complexity.

It is important to note that the most recent investors in a company (the investors in the latest round) will be the first ones to get paid in a liquidity event (”last in, first out”).

A Preferred Stock comes with a Preferred Return attached to it.

While it might seem unfair to investors in prior rounds, this is a way for late stage investors to reduce their risk when investing at a higher valuation.

In VC secondary sales, we look at preferred stock in the event of a liquidation or the sale of an underlying company, in which case preferred stockholders' claim on assets is greater than common stockholders.

4 - Example

As an example, Company XYZ might be raising $100mm during its Series C at a $900mm valuation (pre money) which equates to a $1Bn post-money valuation.

The Series C investors now own 10% in Company XYZ though newly issued preferred shares.

Now suppose that in a worst-case scenario, Company XYZ is sold at a marked-down valuation of $100mm.

Conventional wisdom says that the Series C investors should receive value that is proportional to their investment (10% ownership) which would correspond to $10mm in proceeds at a $100mm valuation. As such, Series C investors would realize collective losses of $90mm via this line of thinking.

Contrary to conventional wisdom, this isn’t what transpires. Rather, thanks to their preferred shares, Series C investors receive the entire value ($100mm) and are the only investors to break-even (or get anything back for that matter).

If you were a common shareholder over the course of these events (e.g. management, early employees), you would realize total and complete losses - a markdown of 100%.

Internalizing this concept is key when understanding investor psychology across stages and rounds.

5 - Pref Shares Secrets

That pref shareholders are the first to get paid is simply the tip of the iceberg. Indeed you can negotiate pretty much anything when it comes to preference.

It helps shed some light on why some GPs decide to invest at sky-high valuations, and why as a common shareholder one should not consider the last valuation as “your valuation.”

Here is a list of what we see in a typical shareholder’s agreement:

• Hurdle Multiple: A multiple on which the preferred return is calculated. A 2x hurdle multiple means that the final investors need to achieve a return of at least 2x before the profits are shared according to the other investors of the cap table.
• Hurdle Rate: A hurdle rate of 10% means that the last investors needs to achieve a return of at least 10% per annum before profits are shared according to the other investors of the cap table.
• Participative Preference (PP): while pref shares in general give you the right to be paid “before” any other investors, participative preference mandates return in advance and “on top” of all other investors. That means if your invested amount is $10mm for 10% of a company and the company is being sold $200mm, PP investors will receive: $20mm (which corresponds to 10% of €200mm) + 10% of ($200mm-$20mm) so $38mm in total. They are taking nearly 20% of the profit while only having 10% equity.

The more aggressive the pref, the higher the valuation can be. The more imaginative the lawyers, the more specificity a pref can adopt.

6 - The waterfall ? Not So Obvious !

A Waterfall looks like this:

Kidding... It’s more like this (illustrative):

The above waterfall allows you to compare the effect of different share preferences (vertical axis) at various exit valuations (horizontal axis).

The waterfall is structured based on this hypothetical timeline of funding rounds (Series A-D):

• Series A: 300k shares at a €12 PPS (Price Per Shares)
• Series B: 500k shares at a €25 PPS
• Series C: 900k shares at a €50 PPS
• Series D: 1mm shares at a €80 PPS (2x hurdle multiple)

In this scenario, there is NO participative preference for shareholders from any round.

The concept of liquidation preference implies that, in any sale of the business, investors with a higher preference will:

1. Receive proceeds prior other investors with lower preference
2. Be the sole recipient of proceeds until their “preferred return” is achieved

Lets study what will happen in a liquidity event considering the different preference of our example:

In the case of Series D investors, the “preferred return” is equal to:

• €80 PPS * 2x Hurdle Multiple = €160 PPS

€160 PPS correlates to a €160mm exit valuation at the firm level:

• €160 PPS * 1mm Series D shares = €160mm exit valuation

Thus, Series D investors are the sole recipients of proceeds until an exit valuation of €160mm is achieved.

For Series C investors, the “preferred return” is simply equal to their entry PPS of €50, because they were not able to negotiate any sort of hurdle multiple or hurdle rate.

With that being said, they still have liquidation preference over Series A and B investors, and receive proceeds until their preferred return of €50 PPS is achieved.

Series C investors reach €50 PPS at a firm-wide exit-valuation of €205mm:

• €160mm Series D exit valuation + (900k Series C shares * €50 Series C PPS) = €205mm

Thus, Series C investors are the sole recipients of proceeds between an exit valuation of €160mm and €205mm.

Along these same lines, we can see that:

Series B investors reach their preferred return of €25 PPS at an exit valuation of €217.5mm

• Sole recipient of proceeds between an exit valuation of €205mm and €217.5mm

Series A investors reach their preferred return of €12 PPS at an exit valuation of €221.1mm

• Sole recipient of proceeds between an exit valuation of €217.5mm and €221.1mm

Now, finally... common shares get a slice of the pie!

There still exists common stock conversion - they key mechanism through which investors with lower preference “catch-up” to investors with higher preference.

Essentially, once preference shareholders have achieved their preferred return, they can trigger a conversion to ordinary shares. With that being said, it is only economical to make such a conversion once the PPS of ordinary shares is higher than the preferred return PPS of the investor’s respective share class (Series A, B, C...).

As PPS for ordinary shares surpasses PPS for each respective share class, conversion occurs sequentially (from lower to higher preference). Thus, as firm-wide exit valuation moves higher, lower preference shares “catch-up” to higher preference shares by sharing in ordinary share value creation.

Finally, when all parties have received the same payout proportion (in this case represented by an overall PPS of €160 or higher), all shares are converted to common shares and share value equally.

7 - Klarna? The Not So Bad example !

Swedish-based Klarna, best known as a “buy now, pay later” service provider, was seeking to raise new funds.

Initial reports suggested the new valuation would be in the region of $15B, representing a sharp decrease compared to its $45.6B valuation only a year prior. As the funding environment deteriorated, some leaks in 2022 suggested that the valuation might end up closer to $6.5B.

That was pretty much how things panned out, with Klarna confirming a $6.7B valuation off the back of $800mm in new money (representing an 85% decrease to the June 2021 figure).

Popular discourse suggests that market trends forced Klarna into a lower valuation to secure funding, however it’s clear that this was not the only factor.

As Klarna is a financial institution, we think the Swedish Government decided to clean Klarna’s cap table by erasing any kind of “preference” between investors.

The UK government did pretty much the same on certain other Fintech names previously.

As Klarna was not able to issue Pref Shares, they were force to price a “REAL” valuation, which was 85% lower.

8 - NotSoLiquid new product: Waterfall and Valuation as a Service (WVaaS)

At NotSoLiquid, we provide waterfall construction and valuation services for startup founders, VC funds, or any investors who have access to their shareholder’s agreement.

By establishing a scenario-driven valuation of your share classes, you will gain a clearer view on what your shares and stock options are worth in both current and future scenarios.

With constant updates on portfolio holdings, NotSoLiquid aims to provide investors with one thing above all else: a greater degree of control.

NotSoLiquid - chasing waterfalls since 2021