The dark side of liquidation preferences

25 Apr 2023

I think the number of founders and leaders, especially at late-stage startups quitting will only increase, making it harder for businesses to survive this funding winter. This is because of liquidation preferences & the disconnect between valuations and business fundamentals.

A liquidation preference allows investors to recover their investment before anyone else. This is how all startups raise money. Nobody thinks of it as a loan, but it is similar. The more money founders raise, the harder it is for them and their teams to see equity upside.

Liquidation preferences are fine as long as valuations are growing and every new round the investments get marked up, and all investors see notional gains. But when growth plateaus or new fund raise at higher valuation becomes tough, the investment becomes like a loan.

Reality strikes when everyone realizes that the valuations have outpaced the business fundamentals. That is, if all the investment has to be returned, there will likely be no upside left for the founders & teams. This is when interest in running the business can drop.

I recently met someone who has raised $100’s million at unicorn valuations but now realizes that the opportunity size isn’t large or growing fast enough to justify the valuations for years to come. It’s a great business, but the founder wants to do something else.

Fantastic businesses solving real-life problems risk not surviving due to core teams quitting because of a realization of a lack of upside due to too high valuations or raising too much. Ironic that the same metrics glorified during the bull run will probably hurt now.

Liquidation preference trade-offs apply to investors as well. New investors will have the highest preference. Maybe this winter will teach investors that businesses must be built differently in India, where M&As & IPOs to overcome liquidation preference issues aren’t easy.

Raising a lot of money at high valuations isn’t always good. It may be for the investors to mark up the investment and improve their fund’s performance. But not for founders and teams, whose equity will keep losing value due to liquidation preference with every new round.

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