Startup Valuations Involving Preferred Equity are Best Viewed as Bonds with Warrants

Image representing Twitter as depicted in Crun...

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People love to talk about startup valuations. The most recent extravagant valuation to make the rounds was Twitter Closing Its $400M Secondary Offering at an $8 billion valuation. On the surface it looks like $400M represents 5% of the equity (assuming the $8 billion is the post-money valuation and not the pre-money valuation). To me, I’m not sure if Twitter is worth $8 billion but that isn’t the right way to think about it.

With preferred equity it is best viewed as a bond with warrants. Here’s why:

  • Preferred equity is often 1x participating preferred (double dip) or 1x non-participating preferred (investor gets all their money back before anyone else). Assuming it is a more entrepreneur-aligned investor with 1x non-participating preferred, there still will be ~10% cumulative annual dividends. What this means is that if Twitter sells for $500 million in 2.5 years, the investors that put in $400 million will get all $500 million and the other shareholders won’t get anything. Do I think Twitter is worth $500 million? Absolutely. This is a low risk investment in my opinion (assuming you’re comfortable making follow-on investments to maintain your position).
  • A bond is senior to equity just like preferred equity is senior to common equity or previous rounds’ preferred equity. That is, in the event of a sale or liquidation, the senior debt and equity get their money back first. Add in the cumulative dividend and the preferred equity looks even more like a bond.
  • Warrants are similar to stock options in that it is the right to buy stock at a certain price. Continuing with the preferred equity acting like bonds with warrants, if the preferred equity was 1x participating preferred and Twitter sold for $8 billion in 2.5 years, the investors who put in $400 million would get $500 million (the original equity plus dividends) plus 5% of the remaining $7.5 billion (double dip) for a total of $725 million. Put another way, the $400 million investment could have been bonds for $400 million with a 10% dividend combined with warrants to purchase 5% of the stock for a penny and they would have ended up at the same point. Would I make that investment? Absolutely.

Arguing if Twitter is worth $8 billion is fun conjecture. In reality, the investment and subsequent valuation aren’t the same as thinking about buying common stock of a publicly traded company, which is how most people think about it. A better way to think about preferred equity is as a senior bond (debt) with warrants to buy stock and participate in the upside.

What else? What do you think of this way to view preferred equity?

3 thoughts on “Startup Valuations Involving Preferred Equity are Best Viewed as Bonds with Warrants

  1. David-

    This is absolutely the correct way to view the economics of preferred equity — preferred investors get the downside protection of a bond through their liquidation preference and the upside protection of a warrant through their participation in the residual. The negotiation around terms (whether it is participating preferred and whether the participation is capped, whether there is an accruing dividend, anti-dilution rights, etc.) are all about how much upside.

    The key differences between typical preferred stock and a bond/warrant combo are on the governance side, where preferred stock sits in the equity/debt stack and in the legal rights. Preferred stock in a startup is voting stock — neither bonds nor warrants typically can vote. And although preferred stock is senior to comon equity, it is junior to all debt, whereas a bond (depending on its security terms) would sit pari passu to other creditors. Finally, boards have fiduciary duties to equityholders that do not (generally) exist to creditors.

  2. David –

    To back you up, the $400 million represents far more of the capital structure than 5% at the time of the transaction. Plus the debt-to-equity ratio of the company has gone way up. I would think using options theory and your bond/warrant model of the company would allow one to value the company more accurately.

    Using this more correct way of looking at the valuations, Twitter today is being valued at far below $8 billion.

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