At Re/Code, Arik Hesseldahl explains how venture capitalists cover their asses and cash:
It turns out that for companies of a certain size, it’s not that hard to get to unicorn status, provided they’re willing to give their investors a lot of assurances that essentially cover their potential losses. The one thing common to every one of these funding deals, the firm says, is that in every case — all 37 of them — investors demanded a “liquidation preference.”
The phrase refers to language often found in an investment contract — and typical to most VC investments — that gives certain investors the right to get paid first ahead of other parties — such as founders or management — in the event the company is sold. If the company sells for a price that is lower than the valuation the investor paid, that investor is the first one in line to receive the proceeds of the sale until they’re made whole. And if the company sells for a higher price, they’re first in line to reap a share of the profit.
What that ultimately means is the investors are taking on very little risk when investing in unicorns, because they stand almost no risk of losing their money if the company goes south.
It’s a win-win world for VC firms.