The majority of startups don’t work out. That means companies may exit for a value less than the amount of cash they raised.

The data is a little old, but Carta crunched the numbers and saw that 254 startups on the platform closed down in Q1 of 2024, more than any other quarter to date, and 58% higher than the prior year period.

With only 20% to 30% of companies who raised a Seed round making it to Series A (Source: Dealroom), liquidation preferences serve as downside protection for investors if the company exits for less than what was initially expected. And it also means the investors get out before the common shareholders (employees + founders).

In exchange for downside protection, investors pay a premium for preferred shares, which may have one of the following features:

This is most relevant when the outcome is below the amount of capital put in. It states how many times over the investor gets their initial investment back before any of the common shareholders get a bite (assuming there’s even enough to get to that total minimum threshold).

This takes Multiple to the next level. It’s relevant when the outcome is above the amount of capital put in (i.e., “the pref stack”).

Participating liquidation preferences, also known as “participating preferred” or "fully participating preferred," allow investors to recoup their initial investment first, and ALSO share in the remaining proceeds like everyone else.

It’s essentially double dipping into the proceeds; first investors get a bite off the top, and then they hop back in line for more.

Capped participating preferred shares put a cap on the total amount preferred shareholders can receive, which benefits the entrepreneur and employees by limiting the investor’s upside. This is less common, but rumor has it that OpenAI had this feature before converting to a real corporation.

Let’s take this liquidation stuff to the next level. There are three types of seniority structures that determine which class of shares get paid out first (Source: Fidelity):

There are some dependent decisions here, as you might have sniffed out, especially when investors are non-participating and deciding whether they want to convert or not.

Therefore, decisions will always start in order of investors with the highest conversion point (typically at the latest stage) to the lowest conversion point. This ensures that conversion decisions are optimal for all parties (Source: Next Big Teng).

Wow, I almost forgot about all the commoners waiting for soup. They get to participate once the boxes are checked for everyone holding preferred shares.

This is why common shares typically trade for less on the secondary market - not only do they come with fewer rights to impact company direction, since they are in the back of the bus when it comes to voting power, they also have the least amount of downside protection.

If you want to be first in line, you’ve got to pay for that insurance policy.

Upon IPO. At that point, almost always, all shares convert to common. That’s why there are so many late stage employees rooting for their companies to limp to the IPO finish line and just go public. It would ensure, even if it’s a lower valuation than their last round, that they get a fair shot at whatever proceeds are up for grabs, as everyone converts to common shares.

This is preferable to going through an M&A process where the preference stack kicks in and chews up most of the value, leaving the employees with whatever crumbs are left.

And to state the obvious, when you sell for more than your last valuation (assuming 1x liquidation preferred), a lot of this stuff doesn’t matter and everyone gets to high five.

Debt always gets paid back first. They’re in front of everyone, including preferred.

So yea, subtract any debt repayments out. The SVBs and other venture debt lenders of the world are the rock to equity holder scissors.

You should know how much money your company has raised. While raising money de-risks the future to a certain extent, and buys you oxygen to survive longer while burning cash, it also cuts into your potential payback. For each dollar you raise, you build that wall a little higher.

For example, if you are working at a tech company that’s raised $500M to date, and the valuation sinks from $4B to $2B, that means upon an M&A event there would only be $1.5B to go around after your preference stack is paid back (or maybe even less, if there are also some participating preferred provisions in there).

So whatever rough math you were doing in your head of “I own this % applied to that valuation” takes a steep discount.

That’s also why it’s so important for founders to take clean term sheets, even if it means accepting a lower valuation. Post COVID, many startups took, to use a less offensive word, “structured” term sheets that allowed them to artificially preserve their latest valuation (read: save face). Guaranteed multiples, in particular, can be a death sentence.

In reality, the headline valuation was all smoke and mirrors - the common shares are worth less than they were before on a risk adjusted basis. Said another way, the company’s risk has been reallocated disproportionally.

Big valuations don’t directly translate to your pocket as a common shareholder.

What takes this from three to four dimensional chess is when you take into account the lifecycle of the fund which your investors made commitments from. Depending on the fund’s age and performance to date, here are five random and hypothetical scenarios to illustrate how there are times when investors are making decisions based more on their own specific scenarios, and less so your company’s:

Not Care:

Push to Sell:

Push to Hold

And the more “structure” you have in your preference stack, the more complicated the scenarios I outlined above become.

Finally, while investors who have structured protection love it, those same terms are a red flag to future investors who realize they’ll be disadvantaged (unless they also slap some provisions on).

Founders should be wary of taking dirty term sheets not only because it makes the liquidation process worse for others on the cap table, but also because it could preclude them from raising future rounds.

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