From the category archives: PWERM
One reason it’s difficult to value common stock in a venture-backed company is that the value of common is more volatile than the value of equity. A small swing in equity value, up or down, can trigger a much bigger change in the value of common. If we’re valuing equity based on market multiples, which change every day, the value of common is likely to bounce around.
The volatility is the result of financial leverage, the same phenomenon which contributes to higher earnings and losses in companies financed with debt. Unless equity value is high enough to trigger conversion of preferred, the preferred liquidation preference is like debt. Equity value may increase by a small amount, but if it all flows to common with none to preferred, the effect on common value can be dramatic. To illustrate, assume a venture-backed company is capitalized with 1,000,000 preferred shares and 500,000 common shares. The preferred liquidation preference is $10 per share, so the pr ...
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