Spoiler alert: It is not possible to review and comment on episode 10 of the HBO show “Silicon Valley,” which aired recently, without revealing some critical plot twists. You are forewarned.
The season finale on Sunday did not disappoint. Season 3 of HBO’s “Silicon Valley” has been truly superb and the writers tied many different plotlines all neatly in a bow at the end. Well done.
The two main narratives from episode 10 worth noting are (1) how momentum drives venture capital behavior and (2) role of liquidation preferences in liquidity events. We will explore both these aspects further. Episode 10 starts with Richard Hendricks and Jared Dunn recognizing that they share a “secret” together on the true nature of their new users. Jared, to help boost morale, gets a Bangladeshi click farm outfit to create fake users for Pied Piper. However, this deceit worked too well. Erlich Bachman, not realizing these were fake users, took advantage of this uptick and strategically leaked it to various venture capitalists. This creates a feeding frenzy where various venture capitalists try to muscle into the deal by offering high valuations to Erlich.
Nothing moves venture capitalists like momentum. Jumping on the train as it is just about to leave the station is every VC’s favorite move. The reason is that momentum is very hard to get. The activation energy required to get a company to a certain degree of progress is very high but once that tipping point is reached many believe that it continues on for consumer startups. Timing is everything in venture capital and the story of venture capital is too early, too early, too early, too early, too late. By jumping on the momentum train you are trying to time your investment just right.
The second plot narrative is around what happens when VC’s force a sale in a company. Laurie Bream, the managing partner of Riviga Capital, decides to put Pied Piper for sale once she realizes that the user growth is fake. The bids are low due to the negative publicity and Richard realizes that he and his team are going to get nothing due to the liquidation preferences.
The term “liquidation preferences” refer to the fact that venture capitalists get preferred shares senior to the founders and management team. These preferred shares act like equity in good times but however if the acquisition value is below a certain threshold they can act like debt. That means, in certain cases, when the acquisition prices are low, all the proceeds go to the venture capitalists and nothing is left for the team.
Many of the private unicorns are going to realize the full impact of this term in the next few years. Good examples would be companies like Gilt Groupe or Good Technologies. Both of them were at one point unicorns (billion\-dollar valuations) but when they were sold recently, the vast majority of the proceeds went to the investors due to liquidation preferences. The reasons were that, below a certain price, investors were entitled to their entire money back not just their ownership.
For example, if investors invested $100 million in a company at a $900 million valuation with a 2x liquidation preference, the investors will own 10 percent of the company. However, if there is an acquisition the investors can choose to get their liquidation preference (2 x $100 million = $200 million) instead of their ownership stake.
This means that, for all acquisition below $1 billion, the investors are going to get their return through the liquidation preference. Many of the unicorn financings that were announced in the last 12-18 months had liquidation preferences and these terms are going to come to roost. Just like the people of Troy had to beware of Greeks bearing gifts, the denizens of Unicornville have to beware of term sheets with liquidation preferences. Caveat emptor.
Image credit: CC by Mark Hillary