It works as follows, there is a line of people who need to get paid,
If the startup took on any debt, at the front of the line is a bank. Their 'note' usually gets paid first. $POOL -= $BANK
When people invested in the Series A, B, C, ... their stock came with a 'liquidation preference' (which can have a few variants, but the two most common are, the investor chooses if they want the liquidation preference or the common value, the investor gets their liquidation preference and the common value. Note that these numbers are in $dollars not in $shares, so if VC A puts in $1M dollars with a 2X liquidation preference they get back $2M dollars. $POOL -= $LIQUIDATION
Sometimes at the same level, or just behind the investors, are convertible note holders, who gave money or equipment in exchange for shares. They often have the choice of getting either their money back, or the shares. $POOL -= $NOTE.
At this point, if there is anything left in the pool it gets distributed to common shares.
A nice rule of thumb is that the most common liquidation preference is 2X (these days anyway) so if the price is < 2X the amount of money raised to date, the common stock will not have any money allocated to it.
And in those situations it makes no difference if your stock 100% vests on acquisition or not, it is still worth 0.
The implicit question is—where the acquisition allocates $0 to common, in what sense are the board of directors fulfilling their fiduciary duty to common shareholders in approving the deal?
Well, their fiduciary duty is to all shareholders and common generally holds a minority ownership interest.
It depends heavily on circumstances, but in a less than amazing sale the acquiring company often wants an incentive for employees to stay. So the acquisition offer will ensure that common gets nothing but they'll be covered by an earn-out over the next year(s).
As you can imagine the negotiation gets very tricky because investors do not generally participate in the earn-out.
The whole thing is well worth reading for anyone involved with VC funded startups. It involved an acquisition with a management incentive plan and preferences that together left nothing for common.
Among other things the court held that where there is a conflict of interest the board must prefer the interests of common shareholders over those specific to preferred (the interests of preferred over common being contractual). It also found that the board had acted procedurally unfairly and in several places suggested outright dishonesty. For those reasons it applied the harshest standard under Delaware law (entire fairness).
In the end however, it found that the company's value as an ongoing concern though not nothing, was not enough to overcome the large liquidation preference and cumulative dividend. Thus, since prior to the deal common stock was worthless a deal valuing them as worthless was fair within the meaning of Delaware law. Note that the litigation lasted 8 years, and at the end of the linked decision it was an open question whether the defendants were going to have to pay plaintiff's legal fees despite having won. (I couldn't find any information on what was ultimately decided there.)
You're not understanding the situation. The board isn't choosing where to allocate the money from the acquisition. The money goes to different classes of shareholders based on previously signed contracts.
The board decides whether or not to take an offer and that offer includes a set of destinations of funds. In particular, the offer may be $Z = $X1 for retention bonuses and $Y1 for purchasing the equity. Or, the offer may be $Z = $X2 for retention and $Y2 for purchasing the equity. The management - who are likely on the board - may want more of the money to go to retention bonuses for senior execs, while the external board members may want more of the money to go to shareholders. And, in many cases, a board member may be involved in negotiating the deal with the acquirer and may push for a particular deal structure.
tl;dr - The board can have significant impact on how the funds get split up, regardless of the previously signed contracts.
If the startup took on any debt, at the front of the line is a bank. Their 'note' usually gets paid first. $POOL -= $BANK
Debt holders do not have priority when the debtor is sold, as the debtor remains in existence. Creditor priority generally matters only where an entity's debt structure is being altered, such as in a bankruptcy, liquidation, or debt restructuring. However, your example is correct if the bank held convertible debt, exercised the option to convert the debt to equity, and the converted equity carried a liquidation preference. (Note that "liquidation" shows up twice in this paragraph but the two usages have very different meanings. "Liquidation" refers to the termination of a corporate business and the distribution of its assets to its creditors and shareholders; "liquidation preference" refers to the maximum return a preferred stockholder may receive when it "liquidates" its holdings in a company as part of an exit event before the common shareholders or subordinated preferred shareholders receive their returns. In the Non-VC world, liquidation preferences are almost always fixed numbers; in the VC-world, liquidation preferences are usually multiples.)
It would be more accurate of me to say that "In my experience, banks require terms in their lending contract
to a startup that results in their notes being paid before anything else."
Clearly there are legal regulations around a company going through bankruptcy and/or restructuring, however when an acquisition is occurring outside the structure of dissolution, which is to say the company is being sold to another entity while it is nominally a going concern, the bank's note may (and my experience does) have specific language to cover that situation and its primacy with respect to where the funds from such a sale might be disbursed :-). The good news is that can also keep a bank from "forcing" a company into default which starts to limit what options they have going forward.
I'm genuinely curious, is a 2x multiple really common these days?
All of the recent raises I've been involved in have been Non-Participating Preferred at a 1x multiple. Or at least capped. I was under the impression that was where everyone had sort of settled these days?
Tell me if I have this right: given a list of all the investors and note holders and their liquidation preferences, you can calculate a fixed dollar amount that gets subtracted from $POOL before it's divided up among the common shareholders.
In the example above, if you've got $2M in $LIQUIDATION and $NOTE is $1M, that means that common shareholders dreaming about buyout money should simply subtract $3M mentally from any sale price they hear.
Yes, pretty much. It is always possible to work backwards from the capitalization table and the termsheets from previous funding and other notes, to figure out how much has to be subtracted off before common sees any return.
If the startup took on any debt, at the front of the line is a bank. Their 'note' usually gets paid first. $POOL -= $BANK
When people invested in the Series A, B, C, ... their stock came with a 'liquidation preference' (which can have a few variants, but the two most common are, the investor chooses if they want the liquidation preference or the common value, the investor gets their liquidation preference and the common value. Note that these numbers are in $dollars not in $shares, so if VC A puts in $1M dollars with a 2X liquidation preference they get back $2M dollars. $POOL -= $LIQUIDATION
Sometimes at the same level, or just behind the investors, are convertible note holders, who gave money or equipment in exchange for shares. They often have the choice of getting either their money back, or the shares. $POOL -= $NOTE.
At this point, if there is anything left in the pool it gets distributed to common shares.
A nice rule of thumb is that the most common liquidation preference is 2X (these days anyway) so if the price is < 2X the amount of money raised to date, the common stock will not have any money allocated to it.
And in those situations it makes no difference if your stock 100% vests on acquisition or not, it is still worth 0.