From Cap Table to Waterfall: How Proceeds are Distributed in an Exit
Takeaway: A "waterfall analysis" is a critical spreadsheet model that shows, dollar-by-dollar, how the proceeds from an acquisition will flow down through the various classes of stock, revealing the actual, take-home payout for every single stockholder.
When your company is sold, the distribution of the purchase price is not a simple, pro-rata calculation. The various rights and preferences of your preferred stock create a complex "waterfall" where money flows from the top down, filling a series of buckets in a specific order. Understanding how to model this waterfall is essential for founders and employees to know what their common stock is actually worth in an exit.
A waterfall analysis is a detailed spreadsheet, typically built by the company's CFO or outside counsel, that models out the proceeds distribution for a range of different sale prices. It is one of the most important financial analyses in the entire life of a startup.
The Steps of the Waterfall
The waterfall flows in a clear, sequential order:
Start with the Total Purchase Price: This is the headline number from the acquisition.
Subtract Transaction Expenses: The first cut goes to pay the lawyers, investment bankers, and accountants who advised on the deal.
Pay Off Any Company Debt: If the company has any outstanding debt, it must be paid off next.
The Liquidation Preference Overhang: Now the preferred stock gets its turn. The proceeds flow down through the "liquidation stack," paying out the liquidation preferences to each series of preferred stock.
If the preferences are stacked, the Series B investors get all their money back first, then the Series A, and so on.
If the preferences are pari passu, all preferred series share the available proceeds pro-rata until their full preference is paid.
The Participation Decision (The "Double Dip"): If any of the preferred stock has "participating" rights, those investors will receive their pro-rata share of the remaining proceeds alongside the common stock after their preference is paid.
The Conversion Point: If the preferred stock is non-participating (the market standard), the waterfall must now model the "conversion" point. At a certain sale price, the preferred stockholders will receive a greater return by converting their shares to common stock and taking their simple ownership percentage of the total proceeds, rather than just taking their liquidation preference. The waterfall identifies this crossover point.
The Final Distribution to Common Stock: Only after all of the above steps are complete does any remaining value flow to the holders of common stock—the founders and employees.
Why the Waterfall is So Important
The waterfall analysis is the moment of truth. It cuts through the complexity of the cap table and shows the actual, dollar-for-dollar economic reality of a deal. It can reveal that in a modest exit, even with a seemingly good headline price, the liquidation preferences of the investors can consume all of the proceeds, leaving nothing for the common stockholders. It is a critical tool for a board to use when evaluating an acquisition offer to understand the true financial impact on every single shareholder.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.