Unicorn deals offer venture investors plenty of downside protection

Big money unicorn financings seem profligate to many outsiders and to an increasing number of venture capitalists, but investors placing tens of millions of dollars with these fast growing companies have significant downside protection on their money.

Unicorn deals, with their billion-dollar-plus valuations, are the talk of the venture business these days. With the status they bring, founders and investors alike seem eager to usher their companies into the club and join big names such as Uber, Airbnb, Dropbox and Square.

For investors with the right deal terms, the transactions appear more rational, and better protected, than at first blush.

The deals typically come, for instance, with liquidation preferences, assuring investors they will get their capital back in the event of a cut-rate acquisition. One in three also have unusually strong guarantees in the event of a less-than-favorable IPO, according to a study by the law firm Fenwick & West.

The upshot is to take the fear of big losses out of the transactions.

The survey found that every unicorn deal reviewed came with liquidation protection, and nearly one in five had senior liquidation protection. In other words, preferred stock holders get repaid their money from a company sale before common shareholders receive a penny.

Senior preferences give investors priority over other preferred shareholders.

On top of that, 30 percent of the financings came with IPO protection, the survey found. Sixteen percent of the deals require a minimum IPO price before an investor’s preferred stock converts to common, typically a requirement of an IPO.

Another 14 percent of investors get additional shares if the IPO price is below a certain level.

“Getting preferred stock gives you these important rights,” said Barry Kramer, a Fenwick partner who participated in the survey. “You’ve got downside protection.”

The firm looked at 37 of the 45 unicorn deals done in the United States during the 12 months ended in March. What it found is that a quarter of the transactions were led by venture capitalists and three quarters by non-traditional investors, such as mutual funds, hedge funds and corporate investors. The average company valuation was $4.4 billion.

It also found that almost a quarter of the unicorns employed a dual-stock structure that gives one class of common stock significantly more voting power than the other. Seventy percent of the 10 most highly valued companies followed this strategy.

What the work points out is that many investors have significant downside protection. For investors with a liquidation preference, a company’s acquisition value could fall on average 90 percent before the investors suffer a loss.

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