Assessing the Worth of Liquidation Preferences Amid Market Declines

Post-Covid, the Venture Capital (VC) landscape has shifted, making it crucial to revisit Liquidation Preference (LP) and its impact on fair value estimation. From 2010 to 2021, the number of Unicorns increased with significant VC funding. By 2024, startups raised funds at flat or lower valuations, with investors preferring leaner, profitable ventures over growth-focused ones. By 2023, insider and bridge rounds increased due to higher capital costs and economic uncertainty, forcing companies to resort to down rounds, affecting equity stakes of founders, employees, and previous investors. Some founders used strategies like convertible securities, specialized terms issuance of SAFEs, and aggressive, tranched financings to avoid recognizing declining values, which are dilutive and often mask the true impact on a company's value.

LP reduces financial risk for new investors and in tough times, securing investment by providing senior LP to new investors can be vital for survival of the Company. However, senior LP can dilute junior and common equity, affecting returns for junior shareholders during exits. Understanding its impact is crucial for financial outcomes during exit events.

Recently, down-rounds are becoming more common due to high valuations and immediate liquidity needs. Preferred and common stockholders often have conflicting interests in exit transactions, with the Board of Directors typically prioritizing common stockholders. Enforcing LP can be challenging but is upheld by contractual agreements and legal precedents. LP becomes crucial during low- to mid-value exits, ensuring recent investors hold seniority and influence over future financing and exit transactions. The hybrid method, combining scenario-based methods and the Option Pricing Method (OPM), can be valuable for valuing investments in early-stage companies with complex capital structures.

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