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Concepts & Tutorials

High Valuations My Ass: Headline Startup Valuation Numbers Hide The Much Lower Risk For Investors

Ola Cabs has raised about $1.18 billion in total, in 7 rounds according to TechCrunch. Recently, it raised $500 million at a valuation of $5 billion. This provides the social media a large amount of content to get agitated about, saying goodness, how can a taxi company that doesn’t own any taxis be worth more than 30,000 crore rupees!

But they aren’t exactly valued at that much. You just got conned by the headline.

Some investor has 10% of the company and they paid $500 million. That’s where the facts stop.

Then you extrapolate, saying oh, if his 10% is worth $500 million, the company should be worth 10 times that?

Wrong.

Because he’s not just an arbitrary investor. He has the power of those two words: Liquidation preference. (LP)

What is an LP? And Why Can’t They Invent Better Acronyms?

To the Second, I am with you. I can feel your pain, though I haven’t held a vinyl record in the last 10 years. We’ll call it “Liq-Pref” but we just know you’ll hate that more. But let’s get back to the story.

A Liquidation Preference is simply this: Dude, I put in $500 million money, you give me some shares, okay, whatever.

But if you sell this company, for any amount, then I first take my $500 million back. Kapish? That’s gone. It’s my capital back to me. You don’t see any of it.

Then, of the remaining money, if there is any, I take my 10% through my shareholding.

This is typically called a “participating preferred” kind of liq-pref. Meaning:

  • If the company sells for less than $500 million, the investor keeps all of it. Founders see nothing.
  • If the company sells for say $600 million, then $500 million goes to the investor, and he takes 10% of the remaining $100 million also. Even if a founder has 90% of the company, he sees $90 million, while the investor gets $510 million.
  • If the company sells for $10 billion, then everyone’s mega happy, because the investor gets his $500 million and the remaining $9.5bn is available to share.

Whatsapp was an example of the last case – they got Facebook shares + cash which were actually worth $18 bn at the time and when the lock-ins expired, they made even more money. But let’s focus on how much risk the investors have actually taken.

The Different Kinds of Liq-Prefs

In the earlier case – the most common – is 1x participating preferred. You also get “non participating” preferred shares – where the investor has a choice to either participate or take out his capital (more common in the US than India). You might even get 2x participating preferred – meaning the investor gets 2x his capital before anyone else sees anything. (that can happen when a company is desperate).

A middle ground is to make it preferred, but optional non-participating, with a certain internal rate of return: So a 24% IRR means that in three years, my $500 million should have become $953 million. So if you sell for $1 billion, I will take my $953 million, and you can have the remaining $47 million split between everyone else. Or, if you sell for $10 billion, then I won’t take the above option and participate with my 10% instead.

And then you get the down ratchets. Meaning, if you take investment in another round, at a lower value than my “headline” investment of $5 billion, then I will ask you to increase my number of shares as if I also invested at the lower value. If now Ola has to take money at a say a $4 billion valuation the number of shares given to the $500 million investor will be higher.

Finally you have the stacked liq-prefs. A fresh investor that’s coming into Ola might simply say I am more recent, so I need more protection – so he takes his money out first compared to earlier investors. In other cases, only angels are stacked below, and all VCs are above.

Basically all these options combine themselves to reduce the risk of the VC. And therefore the VC hasn’t exactly invested at that $5 billion valuation.

The Risk To The Investor?

Effectively to the new Ola investor, he has given debt of $500 million to the company. If the company sells for anything, he first takes his debt out.

Assume the entire $1.18 billion invested in Ola Cabs was given in this manner – with a participating preferred note. All they will care about is: can this company sell for $1.18 billion? If yes, then they’re safe on their capital – they lose nothing.

Effectively, is the company worth $5 billion then? Answer, no.

They have a debt given to the company, of $1.18 billion.

Above that, they participate, which increases their returns, proportionately. That means for them, if the valuation fell to $1.2 billion – a 75% fall in price – no investor will lose money.

When you invest at $5 billion valuation and you also have a put option that protects you from any downside upto a 75% fall in the stock price, you’re really not investing at a $5 billion valuation; the real risk to you is only if the valuation falls below your “guarantee”.

In effect, all the investor has to ask is: is this company going to sell for $1.2 billion at least?

The Risk To Employees and Founders

When you are given stock options or are a founder, you are essentially writing this put option to your VCs. They might additionally have clauses that “vest” your shares over time, allowing them to kick you out and leaving you with less than your earlier share of the company. This compounds your risk, and in effect, you need a massive fairy tale ending before you make big money.

That fairy tale ending is the IPO. Where no liq-prefs come into the picture and your percentage is your percentage. (Typically IPOs are out of the ambit of liquidation preferences, since public markets do not easily forgive such superior rights)

Other than that, the founders and employees might make it big if someone uses an equity printing press to pay them. Like Facebook gave shares to whatsapp, and so many shares that were worth $18 billion (okay, some cash as well was in that number). Effectively, Facebook didn’t have to pay them money – at least, not a whole lot of it. When those shares lost their lock-in, whatsapp investors and founders could sell their bit and realize the money from the stock market (not from Facebook directly).

But anything else ends up being rough on founders and employees. Like a shotgun merger with another company (Flipkart-Myntra?) or a sale that stank of desperation (Ola-TFS?) or many such “acqui-hires” where a company is deemed to be “acquired” but all it ends up being is: return money to investors and hire all the employees.

In the case a CommonFloor-Quikr deal that is apparently 100% stock of the acquirer, and the acquirer is not listed, then what’s the value of what you get? Answer: whatever you want it to be. I can say Quikr is valued at 600 billion dollars, and therefore the 1% stake they are giving me in return for buying my company is worth $1 billion. What really matters is – what exit will Quikr get? If it later gets a $1 billion valuation, you will probably be lucky to make even $1 million after all the liq-prefs.

Your risk as a non-investor is: you’re getting hit for all this risk, if you believe the headline numbers about your wealth.

The Headline Numbers Should Be Ignored

When people raise money, the questions are often like, “at what valuation?”. But the real answer will like hidden in the LP part of an agreement that you and I may never see. There’s nothing wrong with Liquidation Preferences; they are essential in a market that is terribly risky. But in that same vein celebration of higher and higher headline numbers, in the face of extremely skewed investor agreements, is
like partying with empty wine glasses.