The following case studies illustrate demonstrate certain results, individual cases do not guarantee similair future results.
Case Study: This case study demonstrates the opportunity a publicly traded company has, to return capital to investors and provide liquidity to founders to a degree that far exceeds its free cashflow and profitablility without reducing the company's working capital.
Facts:
Company X, a marketer and distributor of electronic cigarette which went public in 2009, through a reverse merger.
On March 29, 2014, the Company filed a Form 10-K with the SEC for the period ended December 31, 2013 on which it reported $25,990,228 in gross revenues and posted a net profit of $801,352. (https://www.sec.gov/Archives/edgar/data/844856/000119312514069730/d682380d10k.htm)
During the same period the company’s securities traded on the OTCQB listing service. There were a total of 42,244 trades for a total volume of 84,869,873 with a market value of $99,429,151. (View the complete OTC record of year 2013 sales.)
Early investors generated approximately $20,000,000 in proceeds from the sale of shares during 2013. The shares appreciated subsequent to the sales, but eventually fell due to mismanagement and a drastic decrease in sales.
Abtract: Former unicorn and Sillicon Valley darling Theranos once had a valuation of approximatley $9 billion and its founder Elizabeth Holmes enjoyed a personal net worth of $4.5 billion, (due to her ownership in the company she founded and led as CEO). As a result of questions of related to the efficacy of its blood testing products and processes as well as government investigations into the Compnay's blood testing results and a termination by Wallgreens-Boots Alliance of their relationship with the Company. The Company's value was marked down to ~$800 million. Based on Homes' ownership interest in the company, one could expect that she would have a ~$400 million net worth, however due to a liquidation preference in the terms sheet which provided her with the capital needed to grow the company, a total of approximately $800 million; Holmes was left with essentialy a zero equity interest in her company. (Bloomberg Article How to lose $4.5 Billion Overnight.)
Liquidation preference: is one of the primary economic terms of a venture finance investment in a private company to specify which investors get paid first and how much they get paid in the event of a liquidation event, such as the sale of the company.
Real World application and Conflict of Interest: Investors and founders have a symbiotic relationship. In the world of venture capital and private equity, Investors (LPs) are represented by venture capital and private equity firms, whose general partners (GPs) identify, vet and invest capital on their behalf. GPs earn a carried interest and management fee for their effort and return on capital (in excess of benchmarks and may face clawbacks in the event of losses). As a result, it is the job of the VC/PE GP, is to protect their investors' capital while attempting to generate oversized returns with big bets in businesses that address big market opportunities. The better the deal the GP strikes for its' investors, at the expense of the founder/company, the bigger the investment return and the larger the carried interest is worth to them; hence a conflict of interest between VCs and the companies they invest in. The concept of the better deal does not necessarily equate to the smaller the valuation of the target company but the agressiveness of other terms, such as liquidation preference. At a liquidation preference of 1x, as long as the exit (sale of the business) is worth the amount of money the GP invests, the GP has preserved 100% of their capital and participates in a pro rata distribution of capital in excess of their preference. Founders and employees and often times earlier investors, only receive a pro rata distribution after the liquidation preference is paid. In essence, the liquidation preference makes the capital investment a loan which is repaid from the proceeds of a sale.