The Risk of a Billion-Dollar Valuation in Silicon Valley

Deep inside a Silicon Valley unicorn lurks a time bomb.

It is a peculiarity of venture capital financing that the engine that pumps money into a promising start-up can later cause the same start-up to self-destruct. With all the hoopla and debate over sky-high valuations of technology start-ups, it is worth keeping in mind that the switch that helps to drive those surging valuations can also be turned off.

The “bomb,” so to speak, is known as a liquidation preference. In every financing round, the money that a venture capital firm invests is not given freely. The firm and the start-up will negotiate terms of protection.

Negotiable terms include voting rights, seats on the start-up’s board and assurances that a future fund-raising won’t unduly dilute the venture capital firms’ stake.

The liquidation preference is among the most important of these protections.

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