When a startup is running low on cash, and can’t get profitable, it has two options: raise capital or sell the business. 

In a challenging funding market—like 2023, 2008, or 2001—both options are problematic. Raising more capital may require a down round. And as we’ve previously discussed, down rounds are incredibly painful.

Selling the business and cashing out might look better than a down round. But let’s look a little closer at one of the biggest challenges that founders face when selling a startup in a crummy market: liquidation preferences.

“liq pref”

A liquidation preference is conceptually straightforward: when the business is sold, investors get their money back first, then everyone else cashes out. (Hopefully.)

Here’s how that works in practice. 

When a startup raises money it sells investors preferred stock. A standard feature of preferred stock is that it carries a “liquidation preference.” The liquidation preference—or preference, or liq pref, is I guess what we’re calling it now?—entitles the investor to either get a multiple of its money back or convert its preferred stock to common stock and sell at the common-stock price. 

Technically, this arrangement is called “non-participating preferred stock.”

Occasionally an investor will both get its money back and convert to common to sell at the common-stock price. That’s called “participating preferred stock” because the investor gets its preference and participates with common. Participating preferred used to be common—especially outside Silicon Valley—but now it’s very rare, even in bad times. Even in the Midwest.

Most liquidation preferences are 1x, meaning the investor just gets its money back (1x the investment).

Occasionally investors will push for a 2x or 3x pref—typically as part of a down round. But like participating preferred, while preferences above 1x used to be more common, they are now quite rare.

Market standard investor terms are non-participating preferred stock with a 1x liquidation preference. 

Don’t let any of those accelerators tell you otherwise! 

Why convert?

When an investor converts preferred stock to common stock, it loses the preference forever because common stock does not carry a preference. That’s true regardless of what happens to the value of the common stock. So if an investor converts and the value of common drops the investor can’t later demand a preferred return of capital. 

You might wonder why an investor would ever convert preferred stock to common. 

Investors mostly convert in two situations: 

1. In an acquisition where the common stock is selling at a price per share above what the investor paid for its preferred stock (most startup acquisitions are structured as a purchase of all common stock), or 

2. Immediately before an IPO where the IPO itself triggers automatic conversion of preferred to common.

By far the most common reason is the first one.

When pref goes bad

Sometimes, particularly in bad times, even at a 1x preference, a startup’s combined investor preferences across all its prior funding rounds—the pref stack—ends up larger than the company’s market value. In other words, the stacked preferences of all seed, series A, series B, series C, etc., investors is bigger than the entire value of the company.

For founders and employees that’s about the worst case scenario. 

It means that if the company was acquired, all of the sale proceeds would go to the investors. The founders and the employees would get nothing. Zero. Zip. 

Building a startup is a lot of work to walk away for zip. 

Here’s what it looks like in action. 

By way of example, here’s what drowning in liquidation preferences actually looks like. 

Say investors bought preferred stock from a startup in the following amounts at these sequential post-money valuations: 

  • Seed: $1.25m invested for 25% at a $5m post-money valuation.
  • Series A: $6.25m for 25% at $25m 
  • Series B: $22.5m for 15% at $150m 
  • Series C: $200m for 10% at $2b 
  • Series D: $2.25b for 5% at $45b

That comes out to a total of $2.48 billion invested and a corresponding $2.48 billion pref stack. Note that most of it came from the Series D. 

(This over simplifies things a bit, ignoring dilution from round to round, and whether investors exercise participation rights—in real life the Seed investors might  end up closer to 15% after dilution—but let’s not over complicate things. Assume the percentages are where each of the investors ended up.) 

$2.48b is a lot of preference, of course. But if the company sells at a $45b valuation or better it’s no big deal, everyone will convert to common and get rich. 

On the other hand, if the market drops and now the company is looking at being acquired for its prior $2b valuation, things are much worse. Preferences typically have seniority in reverse order of investment, so the last money in is the first money out. In this example, the Series D will take the entire $2b, write off its $250m shortfall, and everyone else gets wiped out. 

Now let’s say the offer was negotiated up to $3b. In that case the Series D gets all of its cash back and there is $750m left over. 

The Series C investors have to decide what to do: convert or take the pref? 

In this case, Series C will convert and take 10% of the $3b deal, or $300m—a $100m return on its investment—leaving $450m. 

Series B will also convert and take its 15% of the $3b, or $450m—a $427.5m return on its investment—and that will exhaust the sale proceeds. 

Series A, Seed, the Founders, and the employees will be left with nothing. 

NASDAQ to the rescue!

Alternatively, the company could go public.

As mentioned, going public usually forces the preferred stockholders to convert to common. The conversion ratio under standard NVCA terms is 1 to 1. One share of common for one share of preferred. And since common stock does not have a preference, one result of the conversion is that all investor preferences are wiped out.

In an ordinary market where the IPO is priced higher than the last funding round, that’s fine because investors want to sell at the higher IPO price.

But when the market is down and the IPO is priced lower than the last round—or even the last several rounds—things are not fine. Not for everyone, at least. The most recent investors, who tend to own a small amount of the company purchased at a very high price, may face tremendous losses.

If the company in our previous example chose instead of selling at $3b to go public at the same price, the founders and investors would end up in very different positions.

Instead of getting wiped out, the Seed investors see a 600x return on their investment. The founders and employees would get to split $600m!

Unfortunately, the Series D investors would take a $2.1b loss.

Like the above example, this is also over simplified in that it ignores the dilutive impact of the IPO itself—an IPO being just another financing round, this time offered to the public—and it ignores price fluctuations after the IPO, and the corresponding post-IPO lockup period, all of which could impact actual results.

The main takeaway holds, though: the outcome to investors and entrepreneurs can be vastly different in an IPO than a similarly priced acquisition as a direct result of liquidation preferences.

So what should the company do?

The company itself doesn’t want any particular outcome. It’s a legal fiction. It doesn’t have an opinion of its own.

But the company’s owners definitely want a particular outcome.

Unfortunately they each want different outcomes.

In our example, the founders, employees, and early investors would all prefer that the company go public. But the Series D investors would prefer to force a sale and avoid losing $2.1b.

Either is a viable option. So which way does the company go?

What actually happens will depends on who controls the board and who does or does not have the power to veto things like approving an acquisition or initiating an IPO.

There’s a lot to unpack there and some important nuances.

We’ll get into all that in another post.