A valuation, in theory at least, is a weighted average present value of expected outcomes. Outcomes range from: (1) great performance, (2) good performance, (3) average performance (4) poor performance to (5) disaster.

Given the risk in startups, VCs attribute some weight to scenarios (3), (4) and (5) when doing their valuation. This reduces the weighted average and therefore the valuation. If however, they can implement a structural feature to get protection in these scenarios and therefore have a positive return in those scenarios (or at least loose less), they can justify paying a higher price for the business.

In public stock, investors don’t have these protections indeed but the valuation (i.e. share price) should reflect that.

Then again, maybe VCs even ask for these protection features when the valuation is realistic… ?

I can imagine the scenarios you are painting, and I agree that VCs will want protection against someone taking a $1M investment and selling the company the next week leaving you with $500k.

However, if there is a clause in the contract that guarantees that you can have your initial investment back in a liquidation event, isn’t that the same thing as saying that you want all upside and no downside?

When I purchase shares in a public company, I don’t have a guarantee that I can get my initial investment back. And VC funding is, by nature, more risky, right?

Help me understand this.

A simple liquidation preference goes away quickly when upside is created, but Liquidation Preference is necessary to protect the investor against arbitrage.

Say entrepreneur own 60% and VC’s 40% after investing $4M. Company gets sold for $10M, entrepreneur get $6M, ZERO value created since the round. QED. Not right.

Liquidation Preference forces value creation before exit. One of the few terms I cannot see myself living without.

I don’t like double dip, thought it really depends on the return tradeoff you accept (price vs liqu pref). We will talk about it somewhat in part II.

I know of at least 2 or 3 cases involving tier 1 investors that have never hit the wire.

Very often we move fast and we may not always have the right controls in place. This is why getting decent auditors and getting them to do their job matters, even though none of us like to waste any time doing this (and trust me, I avoid audit committees like the plague ).

I count myself lucky that this has not happened yet to me, but it is possible that a less than completely self-confident CEO of mine may have played around with revenue timing to smooth his financial profile, I may never know!!

Fundamentally it is hard to protect against sophisticated fraud in early stage, and nothing replaces trust and… extensive reference checks. I always like having trusted people in common with people I back.