Many people outside the industry believe that investors always come out on top. In reality, however, the picture is quite different. If a startup fails, investors, particularly those involved in the initial funding rounds, often receive nothing or only small payments.
Why do investors most often lose money?
Startups are inherently high-risk assets. The venture capital industry operates on the expectation that seven to eight out of ten investments will fail, one to two will break even, and only a few will yield significant profits. As a result, losses are commonplace.
The reason investors often receive nothing, even when a company has assets, lies in its capital structure. Startups generally owe debts to suppliers, landlords, banks, and government entities. These obligations have the highest repayment priority. Only after these debts are settled are any remaining funds distributed to shareholders, in accordance with a strictly defined hierarchy.
Another significant factor is the valuation of assets during bankruptcy proceedings. Assets previously valued in the millions, such as brands, patents, and customer databases, may be sold at auction for minimal amounts. In crisis situations, assets are liquidated rapidly and at reduced prices. The lower the proceeds from these sales, the less is available for distribution to creditors and shareholders.
A psychological dimension also influences outcomes. Founders frequently delay declaring legal bankruptcy in efforts to salvage the company. By the time bankruptcy is officially announced, the startup has typically depleted its reserves, accumulated substantial debt, and liquidated or consumed all available assets. Consequently, investors are often left with an entity devoid of value.
'Liquidation waterfall': The order of payments in the event of bankruptcy
A liquidation waterfall refers to the legally mandated sequence in which payments are distributed when a company’s assets are sold. This process can be visualised as a series of buckets placed under a waterfall: funds fill the first bucket, and only once it overflows does the next bucket receive any proceeds. In most startup bankruptcies, available funds are insufficient to reach the final buckets.
Creditors (debt holders)
Secured creditors, such as banks and financial institutions with collateral-backed loans, have the highest priority. If a startup has obtained a loan secured by specific equipment or property, the proceeds from the sale of those assets are allocated directly to the creditor. No distributions to shareholders occur before these obligations are satisfied.
Unsecured creditors, including suppliers, contractors, landlords, and government agencies (for tax arrears and social security contributions), are next in line. Employee-related liabilities, such as unpaid wages and compensation, are treated separately and are protected by law, granting them priority over most other unsecured debts.
Preferred shareholders
Shareholders are only considered after all debt claims have been fully satisfied. Within the shareholder group, a further hierarchy exists: preferred shareholders, often venture capital funds, have priority over common shareholders. Preferred shares typically include a protection mechanism called 'liquidation preference.'
In cases where a company has undergone multiple funding rounds, later-stage investors generally have priority over earlier investors. For example, Series C investors are paid before Series A investors, despite the higher relative risk assumed by the earlier participants.
Common shareholders
Founders, employees with share options, and holders of common shares occupy the lowest position in the hierarchy. In practice, these parties rarely receive any proceeds in bankruptcy, as all creditors and preferred shareholders must be fully compensated before common shareholders are considered.
As a result, despite years of effort and substantial ownership, startup founders frequently emerge from bankruptcy with no financial return, or even with personal debt if they have provided personal guarantees.
What do different types of investors receive?
Venture capital funds (VCs)
Venture capital funds invest via preferred equity with liquidation preference terms. This gives them priority over ordinary shareholders. Large funds also often have pro-rata rights, which give them the privilege to participate in subsequent funding rounds, as well as anti-dilution provisions, which protect their stake from dilution.
Despite these protective mechanisms, venture capital funds typically recover significantly less than their initial investment if a startup goes bankrupt, as the company's assets often fail to cover its debts. For venture capitalists, such losses are anticipated and mitigated through portfolio diversification. Nevertheless, for an individual fund, the loss of several million dollars constitutes a substantial setback.
Angel investors
Angel investors are individuals who provide capital to companies during their early development stages. They may invest via preferred shares, SAFEs (Simple Agreements for Future Equity), or convertible notes. The terms available to angel investors are generally less favourable than those secured by large venture capitalists, offering fewer protective mechanisms, lower payout thresholds, and limited access to complex legal instruments.
In practice, angel investors are among the most vulnerable participants and almost always lose their entire investment if a startup fails. Their only realistic opportunity for recovery arises if the company is sold prior to bankruptcy and the sale proceeds are sufficient to cover their claims, a scenario that is uncommon.
Investors with SAFEs and convertible notes
A SAFE (Simple Agreement for Future Equity) is neither traditional equity nor debt. It is a contract granting the right to acquire shares in the future, typically during the next investment round or upon the company's sale. If bankruptcy occurs before the SAFE converts, the investor receives nothing, as they do not yet hold shareholder status.
Convertible bonds are unsecured instruments that rank below bank and operational debt. While their creditor status theoretically grants them priority over shareholders, in practice, if available funds are insufficient to satisfy secured creditors, holders of convertible bonds also receive no recovery.
Employees with options
Employee share options (ESOPs) grant employees the right to purchase shares at a predetermined price in the future. In bankruptcy, these rights are typically cancelled automatically. If the underlying shares are already worthless, the options lose their value even more rapidly.
Unpaid wages represent a more immediate concern. If a startup fails to pay wages before bankruptcy, employees are granted priority status among creditors. However, the actual amount recoverable is constrained by legal limits and the value of remaining assets.
The role of liquidation preference
Liquidation preference is a fundamental provision in most venture capital agreements. It specifies the portion of proceeds that preferred shareholders receive before any distribution to ordinary shareholders.
The standard arrangement is a 1x liquidation preference, allowing the investor to recover their initial investment (for example, $5 million) before any remaining funds are distributed among all shareholders according to their ownership percentages. However, if the company's assets total only $3 million, an investor with a 1x preference receives the entire amount, leaving ordinary shareholders with nothing.
More aggressive terms include 2x or 3x liquidation preferences, enabling an investor who contributed $5 million to claim $10–15 million before any other distributions occur. These provisions are typically negotiated during crisis periods or down rounds. Such terms effectively ensure that ordinary shareholders receive nothing, even in relatively successful exits.
Participating preferred shares warrant special attention. After receiving their preference payment, holders of these shares also participate in the distribution of any remaining proceeds alongside other shareholders. This structure represents the most aggressive form of investor protection and is the least advantageous for founders and early investors.
Scenarios for the course of events in the event of bankruptcy
Bankruptcy procedures vary significantly depending on jurisdiction, the company's capital structure, and decisions made during the final stages of the process.
In the first scenario, the company ceases operations and undergoes complete liquidation. All assets are auctioned, and proceeds are distributed according to the established priority scheme. This outcome is most detrimental for all parties except secured creditors and typically arises when a startup lacks valuable products, assets, or a functioning team.
The second scenario involves restructuring, such as Chapter 11 proceedings in the United States or equivalent mechanisms elsewhere. The company continues operations under court supervision, renegotiates terms with creditors, and may attract new investment. Investors might retain their equity or receive new shares in exchange for debt forgiveness. This scenario is more favourable but requires a viable business plan and cooperation from major creditors.
The third scenario entails the sale of assets or the entire business, such as a 363 sale in the United States. The company is sold to another entity, typically at a price below market value and within a short timeframe. If the sale proceeds are sufficient to cover outstanding debts, preferred shareholders may receive a distribution. Ordinary shareholders, however, remain last in the payment hierarchy.
In what ways does bankruptcy differ from a down round or an acqui-hire?
It is essential to recognise that bankruptcy is not the sole adverse outcome for startups. Several related scenarios are frequently conflated, despite notable distinctions among them.
A 'down round' refers to a new investment round conducted at a lower valuation than the preceding one. The company remains operational, but existing investors experience dilution or devaluation of their holdings. Although many agreements include anti-dilution provisions to partially protect venture capitalists, these mechanisms are not universal or always effective. Despite being unfavourable, a down round does not constitute bankruptcy, as the potential for profit remains.
An acqui-hire occurs when a company is acquired primarily for its team rather than its products or assets. The purchaser pays only enough to secure key personnel, who subsequently join the acquiring organisation. The transaction value is typically minimal, sufficient only to settle primary debts. In this scenario, most investors receive little or nothing, although the process is generally faster and less damaging to reputations than liquidation.
How investors try to protect their money
Experienced investors implement a range of protective measures in their agreements to mitigate risk and increase the likelihood of recovering at least part of their investment in adverse scenarios.
Liquidation preference is one such mechanism that grants investors priority in payout distributions. Additional tools include board representation, which enables investors to influence strategic decisions, such as the timing and manner of bankruptcy declarations or company sales. While these measures do not guarantee a return, they provide greater control over the process.
Drag-along and tag-along rights are critical in the context of a company's sale. Drag-along rights permit majority shareholders to compel minority shareholders to sell their shares if an exit is pursued. Conversely, tag-along rights allow minority shareholders to sell their holdings on the same terms as the majority. Both provisions are essential in structuring mergers, acquisitions, or crisis-driven sales.
Information rights require companies to provide regular reports to investors, facilitating the early detection of potential issues and enabling timely intervention. Qualified investors frequently negotiate rights of first refusal, granting them the opportunity to purchase new shares in future funding rounds or to block specific strategic transactions.
Risks for private investors
Large venture capital funds benefit from legal teams, meticulously structured agreements, and diversified portfolios. In contrast, private investors—such as business angels or individuals investing personal savings in acquaintances' startups—are considerably more vulnerable.
First, private investors frequently enter agreements lacking protective provisions, such as liquidation preferences or anti-dilution clauses. As a result, they become ordinary shareholders and, in bankruptcy, are last in line for repayment.
Second, information asymmetry places private investors at a disadvantage, as founders possess significantly more knowledge about the company's status. By the time external investors recognise issues, the company may already be in crisis. Without information rights or board representation, private investors often learn of bankruptcy only after it has occurred.
Third, equity crowdfunding creates an illusion of control for small investors, granting access to early-stage startups with minimal capital commitments. These investments are typically structured through SAFEs or as microshares of ordinary stock. In bankruptcy, such investors lack influence, priority, and legal recourse for recovery.
What to consider before investing
Prospective investors should consider the following key questions before entering into any agreement:
What is the company's capital structure? What is the current debt level? Who holds priority in the liquidation waterfall? If the company has substantial debt to banks or prior venture capitalists with aggressive liquidation preferences, the likelihood of recovering any funds in bankruptcy is minimal.
What rights are conferred by the agreement? A SAFE lacking supplementary terms functions as a donation if bankruptcy occurs before conversion. Does the agreement include a liquidation preference or an anti-dilution clause? What is your standing relative to other shareholders?
What information rights are provided? At a minimum, investors should receive quarterly reports and access to key financial metrics. Without such provisions, investments are made without adequate oversight, and problems may only become apparent when it is too late to intervene.
What is the true liquidity of the company's assets? If the primary assets are intellectual property, software, or brand value, their auction prices may be negligible. Companies with tangible assets, such as equipment, property, or inventory, offer somewhat better prospects in liquidation.
How diversified is your investment portfolio? It is prudent to avoid investing an amount in a single startup that could materially impact your financial position if lost. Although this principle appears straightforward, it is frequently overlooked, especially when investing in ventures led by acquaintances or persuasive founders.
Startup bankruptcy follows a rigorous and transparent process. Investors who structure deals appropriately, implement protective mechanisms in advance, and secure favourable positions within the capital structure are more likely to recover some portion of their investment. Others are relegated to the end of the repayment queue, where little or nothing typically remains.
