Christopher Mims had an article in the Wall Street Journal recently titled “The Dangers Ahead if Tech Unicorns Get Gored.” In his article, Mr. Mims discusses the potential collateral damage of a failed unicorn. The article is thought provoking and includes two quotes that highlight aspects of venture capital that are important to understand. Venture capitalist and Stanford Professor Heidi Roizen is quoted as saying “Venture capital is not free money. It’s debt.” And Michael Moritz of Sequoia Capital is quoted as calling many unicorns “subprime.”

Venture Capital as Debt?

Looking at venture capital as “debt” is worthwhile for any entrepreneur, as doing so may prevent misconceptions as to how preferred equity works.

As an initial matter, venture capital technically is not debt.

• VC’s typically buy preferred equity – they are issued stock certificates (not promissory notes)
• VC’s do not receive security interests or personal guarantees
• VC’s seek a return on investment that will be a multiple of their investment (as compared to a fixed rate of interest)
• In a debt collection scenario, real lenders and creditors have priority over all shareholders, including the VC’s

Having said that, venture capital is like debt in many ways. Professor Roizen’s blog post provides an excellent explanation.

• Most notably, preferred equity has a liquidation preference — when the portfolio company is sold, the VC’s investment money is returned first (like a repayment of principal)
• The liquidation preference often comes with accrued dividends (like payment of interest)
• VC’s typically receive a set of control rights (like covenants are provided to lenders)
• Preferred equity typically has a redemption feature, so that the shares must be redeemed after five to seven years (like a loan has a maturity date)

We’ve reviewed the potential effects of liquidation preferences in prior posts. The key to understanding the potential impact of VC terms is to model out a few “waterfalls” – spreadsheets that illustrate the flow and allocation of funds in a sale transaction.

Subprime Unicorns?

Continuing the debt analysis and considering how such debt could be “subprime” is a useful consideration for entrepreneurs and investors alike.

“Unicorn” and “subprime” are seemingly contradictory terms. Unicorns are start-up companies that have been successful in commanding a valuation above $1 billion. But at their lofty valuation, there may be increased risk that the valuation does not hold up. If it doesn’t, the debt-like features of a VC’s investment may take center stage (like aggressive lending terms in a subprime loan). The liquidation preference may be the VC’s predominant or only source of return.  And the founders may find their return, if any, subordinate to several layers of liquidation preferences that are tied to significant rounds of investment. In both cases, neither constituency is happy.

Questioning the quality of VC investment in unicorns may prove to be prescient. And as Mr. Mims explores, the consequences of a failed unicorn may be far reaching. But for now, simply understanding how a headline grabbing VC investment could be likened to subprime debt offers valuable insight into how VC investments are structured.

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