A study by law firm Fenwick & West found that, during the year ending March 31, 2015, 30 percent of 124 venture-backed companies that raised capital when their valuation was $1 billion or more used ratchets or other IPO protections. Anecdotal evidence suggests that percentage is higher today.
Such arrangements guarantee late-stage investors against losses, but come at the expenses of early investors, founders and employees with stock options who are diluted and so would see their returns diminished, or even eradicated entirely. That produces a chilling effect that snowballs. As more late-stage investors in private companies demand increasingly better terms, fewer investors are interested in making earlier investments.
Eventually, the IPO pipeline freezes up, unicorns get frostbite and lose their precious horns. Unfortunately, that is where we are today.
The good news is that just like after the 2000 Nasdaq crash, the ensuing shakeout will separate the great companies from the bad ideas. Investors will then have a contrarian buy signal, because many of these imaginatively valued high-flyers will become bargains.
Commentary by Phil Wickham, CEO of the Kauffman Fellows. Founded in 1994, Kauffman Fellows is a Silicon Valley-based leadership program for venture capitalists and innovators. The more than 400 graduates from this two-year apprenticeship, collectively known as the Kauffman Fellows Society, now lead venture capital, government, corporate, university and startup innovation in over 50 countries around the world. Reach them @KauffmanFellows.
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