Liquidation preferences, divergence between valuations and business fundamentals can impact startups seeking funding: Nitin Kamath

“I expect the number of founders and leaders, especially late-stage startups, to leave will increase, making it more difficult for businesses to survive this funding winter. This is due to liquidation preferences and valuations and business fundamentals. This is because of the disconnect between,” Nitin Kamath said via a tweet.

Highlighting the liquidity preferences, the Zerodha founder said, “A liquidation preference allows investors to recover their investment before anyone else. This is how all startups raise money. No one thinks of it as debt, but it is Ditto. The more money founders raise, the harder it is for them and their teams to see equity rise.”

Highlighting the relationship between valuations and liquidity preferences, Kamath said through a Twitter thread that “as long as valuations are rising and investments are marked down in each new round, liquidation preferences are fine, and All investors see imaginary profits. But when growth plateaus at high valuations or it becomes difficult to raise new funds, investing becomes like debt.”

“Reality strikes when everyone realizes that valuations have outstripped the fundamentals of the business. That is, if all investments were to be recouped, there would be no upside potential left for the founders and teams. This is when interest in running the business may wane,” said Nitin Kamath.

“I recently met someone who raised $100M at a unicorn valuation but now feels the opportunity is not large enough or growing fast enough to justify the valuation for years to come. It’s a good business, but the founders want to do something else,” he further added in his Twitter thread.

Highlighting how high valuations can affect startups, the Zerodha founder said, “Real-life cases of core teams leaving due to realizing the lack of upside due to very high valuations or raising too much Brilliant businesses that solve problems cannot survive. The irony is that the metrics that were glorified during the bull run will probably hurt now.”

Commenting on how liquidity preferences can affect investors, Nitin Kamath said, “Liquidation preference applies to trade-averse investors as well. New investors will get the most preference. May be this winter will be beneficial for investors.” Teach us that businesses should be built differently in India, where mergers and acquisitions and IPOs are not easy to overcome issues of liquidation preference.”

Highlighting about startups announcing fund raise with higher valuations, the Zerodha founder said, “Raising a lot of money at high valuations is not always good. It can be for investors to mark invest and improve their fund performance. But not for founders and teams, whose equity will continue to lose value with each new round due to liquidation preference.”

Responding to Nitin Kamath, Vaibhav Domkundwar – CEO & Founder – Better said, “Founders who “knowingly raise capital that piles up liquid prefs” and who then think they should leave because of liquid prefs they have Bought it myself, probably should never raise capital again – that’s called bailing out. Mission oriented founders don’t bail out. Lots of stories for 2001 and 2008 where founders pulled it out and built it successfully. Somehow it reads That leaked prefs are a bad thing that investors do to founders – quite the opposite.”