Seniority Matters

By Dan DeWolf

There is little doubt that activity in the trading of secondary shares of private companies remains robust. Private companies are staying private longer and there seems to be an unlimited demand to buy into the newest “Unicorn” anointed each week.  As the market for secondary shares stays strong, valuations seem not to matter much to most buyers. Additionally, many buyers seem to pay little attention to whether they are buying senior preferred stock at the top of the stack, as compared to junior securities or common stock sold by many former employees.  But as we all know, things that can’t go on forever, don’t.  And, as Warren Buffet once famously said:  only when the tide goes out do you discover who has been swimming naked.

At some point a number of these Unicorns will become Unicorpses.  We recently saw this with the sale of Good Technology to Blackberry at a huge discount to valuations achieved only weeks prior to the sale. And when these companies are forced to sell (often in order to survive), where a stockholder stands in the stack is of critical importance.  

In a sale of a company, after the payment of deal expenses and any carve out for management, the senior preferred stockholders receive their money back first. After holders of the senior preferred get paid, then holders of the junior preferred are paid.  Lastly, the residual proceeds if any, is paid to the common shareholders.   In many sale situations, particularly if a sale is the only alternative to survival, the common shareholder walk away with zero.   The closer you are to the top of the stack, the more likely you will at least receive your money back.  The closer you are to common, the greater the chance you will receive back less than your basis.

In an era where investors are making wild bets on companies that often lack meaningful profit margins or even meaningful revenues, and doing so relatively blindly without receiving  the normal financial information generally available to investors in the public markets, it really does matter that you are as close to the top of the equity stack as possible. For when the market turns just a little bit South, as it inevitably will, you really don’t want to be the one swimming naked.