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?