Understanding the Waterfall

In the most common upside scenario, when an investor-backed startup gets sold, the distribution of the sale proceeds is called the waterfall. Understanding how waterfalls work helps startup CEOs and investors grasp the implications of various fundraising terms.

Excitement abounds when a startup approaches an exit transaction – whether it is the more common strategic acquisition or the rigorous IPO process. If the valuation is attractive, this is the hopefully win-win-win moment that everyone involved has been dreaming of and working for.

When a company is sold either to the public (IPO) or to another company (acquisition), the proceeds from the transaction are distributed to the company owners (stockholders) in accordance with the corporate charter and bylaws, which reflect the terms and conditions of investment. High-potential startups that have taken significant investment capital often have a complex ownership structure with a hierarchy of valuations, preferences, and rights that apply to different investors differently. The totality of these rights and ownership stakes play out in the “waterfall.”

Understanding the “Waterfall”

While each startup’s situation is unique, and some details of the “waterfall” will not be known until an exit transaction is negotiated, some general elements are helpful to be aware of in the earlier days when a startup is fundraising. As a framework, the following “waterfall” of proceeds may help in understanding, in general, who will get what:

Total Proceeds: The “top” of the waterfall starts with the proceeds from the exit transaction, paid by the buyers. Buyers may be the acquiring company or underwriters and new public shareholders in the case of an IPO. Proceeds are likely to be some combination of cash, acquirer’s stock, or potentially other assets. On the surface, it seems simple, however, the total proceeds can have some negotiated nuances. For example, some portion of the proceeds may be held back in escrow to accommodate post-exit expenses, indemnification obligations, or post-closing purchase price adjustments. Some deals also include earnout provisions that mean that some portion of the deal proceeds depends on achieving pre-specified future milestones. For the rest of this generic illustration, I will just track through an all-cash deal for simplicity’s sake.
Transaction Costs: Immediately deducted from the total proceeds will be the payments to the service providers who helped facilitate the exit transaction. For example, these will be the investment banker fees (often a percentage of the total sales price), the legal fees, and other transaction-related fees. Remember that the expertise, relationships, and risk mitigation investment banking and legal professionals bring to a transaction are very valuable.
Debt: The next layer for payouts is the debt holders. Looking at the company’s balance sheet, anything that appears as debt on the liability side will likely be paid out of proceeds next, except for working capital debts usually incurred in the ordinary course of business within whatever limits are negotiated in the transaction.
Preferred Stock: The subsequent payouts will generally go to the preferred stockholders, which can include unconverted SAFE notes. Preferred stock is so named because it has “preferential” payout rights relative to the common stock. Most commonly, the latest money invested in preferred stock has the most senior preference. For example, Series C shares will generally be senior to Series B shares that will be senior to Series A shares. However, it is possible for the preferences to be defined differently in the fundraising negotiations. The amount of the preferred payout will often be expressed in terms of a multiple (like 1x, or less commonly 2x, etc.) of the amount of money (x) that the shareholder paid for their preferred shares. Once all the preferred preferences for each series of preferred stock are fully paid out, we move to the common stock.

If the deal is a good one for the selling company, then preferred shareholders may have a “choice” to make. If their preferred shares are “non-participating,” then the preferred shareholders may choose to either take the value of their preferences (as described above) or convert their shares into common stock and take the proceeds they are entitled to as common stockholders. Of course, this is likely not to really be a “choice” so much as every preferred shareholder in each class of preferred stock takes the best deal – either the preferences or the converted value. Once someone does the math, there will be an obvious answer because who would deliberately choose to take less when they can have more? For example, if, as a preferred shareholder, my preferences are worth $100,000 and the value of my shares, if converted to common stock, is worth $500,000, I and everyone similarly situated to me would choose conversion. If the value of my preferences is $50,000, and my converted value is $10,000, I, and everyone in the same class as me, would choose my preferences.

It can get even trickier to follow if one or more of the preferred series of stock is a “participating preferred.” In that case, the participating preferred shares first receive the value of their preferences and then, in addition, convert their shares into common stock and receive additional value for the converted preferred shares as a common stockholder. Think of it as double-dipping because the preferred stockholders get their preferences and then participate in the value distribution to the common shareholders.

Common Stock: Once all payments in #2-4 are made, the remainder is distributed to the common stock, which is what most founders and team members (with vested options, with the sometimes negotiated possibility of accelerated vesting upon exit provisions) hold in a startup. All of the proceeds remaining after distributions higher in the waterfall are divided equally by the number of common shares, which is the value paid to those shareholders. Remember that, at this point, the common stock may also include converted-to-common shares of preferred stock.

Now, we have completed the waterfall!

Scenarios and Implications

In the best case, the company sells for a high price, and abundant proceeds flow down the waterfall, which makes everyone quite happy!

Sometimes, however, the proceeds are insufficient to make it all the way down the waterfall.

Perhaps there are only sufficient proceeds to pay out the preferred stock preferences, and the common stockholders get nothing.
Or, perhaps, there are only enough proceeds to pay some of the preferred series of stock (say, the Series C gets paid their preferences, then the Series B gets paid their preferences, and the Series A only gets part of their preferences with the common shareholders getting nothing.)
Or, perhaps, there are only enough proceeds to pay the 1x participating preferred preferences, and the remainder, once the preferred convert into common shares, means that the preferred shareholders end up getting 1.2x their money, and the common shareholders get much less because they had to share quite a bit of the proceeds with the participating preferred.

Clearly, many variations on the story can unfold. Many spreadsheet models will be built to analyze and understand the possible payout scenarios and to identify where the interests of various classes of investors/shareholders diverge.

As part of investing and raising money, it is important to understand the possible waterfall scenarios during the negotiations. Sometimes, provisions can be added to keep everyone as aligned as possible or incentivize certain groups with sweeteners. The danger is that if a company raises money with a high preference (e.g., 2x or 3x), there is a tendency for subsequent rounds to want the same “extra” preference, and that can mean that it is challenging to sell at a price where the proceeds make it all the way down the waterfall. When a company has to raise money under duress, such as during a difficult fundraising environment with many down-rounds, the implications for the waterfall and future proceeds-sharing can shift wildly as onerous terms are added to incentivize investors to put money in. When that happens, careful thought needs to be given to ensure that incentives for management and investors are considered to avoid creating dysfunction that could impair the company’s future success – and the hoped-for proceeds.

Hopefully, I have not painted too dark a picture. There are plenty of cases where the abundant flow of proceeds in the waterfall rewards all the stakeholders in the company well – and there is grand celebration! May it always be so!

Disclaimer: The detailed distribution of proceeds waterfall in an exit is always unique to each startup and the terms on which it has raised money, so think of this post as providing a basic framework and be sure to check your understanding with your corporate attorney, who can provide insight into the specifics of your situation.