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.