The importance of the valuation to investment ratio in unicorn deals

The ratio of a unicorn’s valuation to the total investment it has received (the “V/I ratio”) has been declining in recent quarters, and if that trend continues we can expect the terms of future unicorn financings to become tougher for companies.

Below is a graph of the V/I ratio by quarter for U.S.-based unicorns on their financing date.

By way of explanation, venture capitalists calculate a company’s total liquidation preference (generally the aggregate amount of money previously invested in a company) before investing. This is done for two main reasons. One is to understand how much money has to be paid to prior investors on a sale of the company before the new investor would receive a return on its investment. The second, and similar, reason is to understand how much money needs to be paid to prior investors before company management receives proceeds from the sale of the company, as a new investor wants to make sure that management is properly incentivized before it invests.

If a potential investor determines that the liquidation preference of a company is too high relative to the valuation of the company, then the investor may require the company to provide it with a senior liquidation preference, so that it is assured of receiving its investment back before prior investors receive any proceeds, or maybe even a multiple liquidation preference, which would provide the investor with a multiple of its investment back before prior investors receive any proceeds. Alternatively the new investor might require that past investors give up some or all of their liquidation preference (generally by converting some or all of their outstanding preferred stock to common stock) to increase the amount that the new investors (and management) would receive on a sale of the company.

For example, if there are two companies with the same valuation, say $1 billion, but one has previously raised $100 million to obtain that valuation, and the other has raised $600 million to obtain that valuation, venture capitalists are likely to require tougher terms to make an investment in the second company, even though the valuation of the two companies is the same.

To date we have not seen a significant increase in the use of these tougher financing terms in unicorn financings, although the use of senior liquidation preference did spike up in the fourth quarter of 2015, and there have been relatively few unicorn financings in the first half of 2016 to draw any additional conclusions. However, if valuations continue to weaken, and/or if companies continue to raise additional financings without significant increases in valuation, the V/I ratio will by definition continue to decline, and the negotiation of the terms of venture investments can be expected to become more complicated and painful to current investors.

Barry Kramer is a partner at Fenwick & West. This piece was originally published here.

Illustration courtesy ©iStock/julymilks