Looking at the capital stack of a startup is starting to remind me of looking at a structured credit product.
Common stock, Series Seed Preferred, and Series A preferred shares are all deepening in their subordination to the shares of later stage rounds. This is happening as later stage rounds become increasingly structured, as companies raise at higher and higher valuations, stay private for longer, and as they raise more capital in later rounds — increasing the hurdle they need to hit before 1x liquidation preferences get wiped in exchange for a more attractive conversion to common.
And throughout all of this, we keep using the term valuation incorrectly. We basically take the price of the most senior security of a company, and ascribe that value to all of the subordinate securities. Which is really dumb. That’d be like saying subordinate debt is as valuable as senior debt. It’s not — and that’s why sub debt holders get higher yield, for taking more risk.
Seed and Series A investors are essentially the subordinate debt holders, at the bottom of the waterfall, but hoping for the higher yield if things go well.
And it’s important that VC firms start finding ways to reflect this on their book, start realizing how far down the waterfall they are, and start realizing what this means as exits come at lower valuations than the price of their last round.
I think seed investors, series A investors, and common stock holders are going to start getting wiped out of their winners more often — because they are holding the stock long enough for their portfolio companies to get launched, scale, become winners, and then get disrupted again. And in this final stage, the high valuations and large rounds are going to hurt everyone — and worst of all, they’re going to hurt the employees.
