Paying Investors if Your Company Fails

On February 16, 2013 by Alexander

It’s important to remember that venture investors buy equity in the startup, not debt. Equity has an unlimited upside if the startup does well, but the investors get nothing if the startup value goes to zero. Debt has a limited upside. When a startup sells a bond to a bank, the bank can expect to get a certain interest rate annually and the sum of its investment returned at the end of the loan term. If the startup’s value goes to zero, the bank has certain legal procedures it can go through to get at least some of its money back.

Startups are highly risky, but can involve a big payoff. Also, they seldom build up any significant assets to sell in the event of bankruptcy. It’s a bad bet for a bank to buy startup debt, but it’s a reasonable bet for a venture capitalist to buy startup equity.Let’s look at the venture capital situation, where there are three major types of failure:

A startup can (A) fail to meet investor expectations, but still be acquired by a larger company (B) fail to make any money, but still have assets that can be sold (C) fail to make any money and fail to make a product or assets that can be sold. Let’s look at what happens in each event:

(A) If a company is acquired for a price that fails to meet investor expectations, it may trigger “liquidity preferences,” a clause in preferred stock agreements that ensure the venture capital investors get paid first and at a multiple of what they invested. Most term sheets include liquidity preferences.

(B) The assets will be sold and any money made on the sale will likely be split among the preferred shareholders in proportion to their stake. Alternatively, the company can be sold to a venture liquidator, a type of firm that focuses on “orderly shutdowns” and squeezing the value out of failed startups. Either way, VCs get paid first because they own “preferred shares.”

(C) Everybody loses. Nobody has to pay the venture capitalists anything, they’ve just lost their money.

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