Every time you raise money you negotiate the terms for that private placement. Lets say your start up has 3 rounds, A, B, and C, and raises $1M, $2M, and $10M with a 1x liquidation preference. Now you're business is sagging and you're about to close up shop, but an investor comes in and says "We'll provide the money but we want 3x senior liquidation" which is to say they get paid back 3X their money before anyone else. Lets say they put in $1M, and the company sells for $3M. It all goes to the last investor because they were senior in liquidation rights. Nobody else gets any money.
In terms of that last raise it is sometimes "nothing" (ie close the doors) or one more shot at making it. So from the founder's perspective the 'close the doors' option has them getting nothing, and keeping it alive long enough to sell it may or may not give them a return.
It's not at all uncommon. My third startup, Smart Charter, was acquired pre-launch by Richard Branson and launched as Virgin Charter. Virgin then ran it into the ground. I never saw a dime. :-(
Sounds like some investors took a wash too, so it's likely they had significant debt. Otherwise, it's because other investors held liquidation preferences (possibly at a multiple).
Liquidation is usually the multiple of the investment money, that the investor gets back before anyone else gets their money. Like earlier explained, later investors generally get senior rights to earlier investors; so they get their money out first.
It's simply about (real or perceived) risks. A senior liquidation preference is a way of mitigating risk for later investors by increasing the chance they can get a return on their investment, or at least their money back in the event things doesn't do great, while giving up less upside potential for earlier investors if things does go great.
