What does a waterfall look like?

Takeaway: A waterfall is a critical tool in startup acquisitions that tracks how the proceeds from an exit would be distributed among various equity classes, providing clarity on potential returns under different exit valuation scenarios.

Startups often secure funding through preferred stock, which comes with specific rights, one of the most significant being the liquidation preference. In an acquisition, where the company's assets are liquidated, understanding the mechanics of these preferences is crucial. To keep track of these often complex arrangements, startups and investors use a tool called a waterfall. Here’s an explanation of what this looks like.

Overview of a Waterfall

A waterfall is essentially a detailed and dynamic cap table that shows the payout structure in various exit scenarios. It takes into account all types of equity issued (common shares, preferred shares, etc.) and outlines the order of payouts based on the terms agreed upon in the financing documents.

Key Components

  • Share Classes: The spreadsheet takes into account all classes of shares (Series A, Series B, Common, etc.).

  • Number of Shares: This indicates the total number of shares for each class issued by the company.

  • Liquidation Preference Per Share: This outlines the monetary preference each share class has upon liquidation. For instance, Series A preferred stock might have a $1.00 liquidation preference per share, meaning they're entitled to receive $1.00 per share before any proceeds are distributed to the common stockholders.

  • Liquidation Multiple: This defines how much the holder of a preferred share is entitled to receive before any remaining proceeds are distributed. For example, a 1x liquidation preference entitles the holder to receive 1 times the original investment amount before any remaining proceeds are shared.

  • Participation Rights: This column indicates whether the preferred stock "participates" with common stock after receiving its liquidation preference.

  • Proceeds: This is where you model different exit scenarios. For example, you might want to see who gets what if the company is sold for $50 million, $100 million, etc.

  • Payouts: This column calculates the payout for each class of stock in each exit scenario, considering the liquidation preferences and participation rights.

Conclusion

A well-prepared waterfall is an essential tool in startup exit scenarios. It helps stakeholders understand how the proceeds from an exit would be distributed among the different classes of equity. Furthermore, it provides clear insights into the implications of different exit valuations, aiding in negotiations and decision-making processes. It's always advised to consult with experienced legal and financial advisors while dealing with these financial models, given their complexity and importance.