What happens when a company is acquired for less money than it raised in funding?
Every investment round in a company is made on the basis of extensive paperwork (often upwards of 100 pages in total) specifying *precisely* what happens when it comes time to pay out the proceeds (if any) from the sale or dissolution of the company. And since all prior investors sign such agreements—or are otherwise legally bound by them—there is never any confusion about exactly what will happen under any particular outcome.
In many, if not most, seed and early stage funding scenarios, the investments are structured in LIFO order: Last In, First Out. The technical term for this is the “liquidation waterfall”, because on a liquidation event (whether good, as in a large buyout, or bad, as in a distress sale, investors (and others) get paid out in a specified order. After one “pool” of investors (say, all those in the Series A round) is filled up, any remaining cash “falls down” to the next pool, until IT is filled up…and so on all the way down the line. (In some other cases, all Preferred investors are treated pari passeux, so steps 5/6 and 7/8 below would be combined into one.)
Also, as Ben Black mentioned in his answer, in some cases the investors may choose to provide an incentive to the management team, in order to ensure that the sale goes through, and quickly. That is usually done by setting aside a fixed amount, or a percentage of the purchase price, which gets divided up among the management team and gets paid out before the investors start getting paid back.
So, here is the typical payout order, from first to last:
1) Salaries owed to employees
2) Secured creditors
3) Un-secured trade creditors
4) Noteholders (convertible and other)
4.5) Management carve-out (if any)
5) Senior Preferred Stock and warrants
6) Any preference multiple on (5)
7) Junior Preferred Stock and warrants
8) Any preference multiple on (7)
9) Common Stock (including any Preferred that converted to Common, any exercised options, and all Founders stock) and Common stock warrants
If a company hasn’t taken in any outside financing at all, things are very simple, because the liquidation waterfall jumps directly from (1) down to (9). But for a company with multiple rounds of equity and/or debt funding, things can rapidly get so complicated that the only way to figure out who gets what, when, is to use a specialized computer or web-based program:
Written by David S. Rose
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