Waterfall Distribution: Who Gets Paid First?

A waterfall distribution, often simply called a "waterfall," is the order of priority in which returns from an investment are distributed among different classes of investors and stakeholders. Understanding the waterfall is crucial for investors as it determines who gets paid first and how much in various exit scenarios.

What Is a Waterfall Distribution?

The term "waterfall" comes from the visual concept of water flowing down from one level to the next. In investment terms, this represents how proceeds from a liquidity event flow from one class of stakeholders to another, typically in order of seniority or preference. Only after higher-priority claims are satisfied do the proceeds "flow down" to the next level.

Why Waterfalls Matter

Return Expectations: Determines actual returns investors will receive
Risk Assessment: Helps investors understand downside protection
Investment Decisions: Influences whether to invest at certain valuations
Negotiation Points: Key terms in investment agreements

Common in Various Structures

Private equity and venture capital investments
Real estate investments
Hedge fund carry distributions
Private credit investments
SPAC merger scenarios

Basic Waterfall Structure

Typical Priority Order

Senior Debt: Bank loans, bonds, and other senior obligations
Subordinated Debt: Mezzanine financing, convertible debt
Preferred Equity: Preferred shareholders with liquidation preferences
Common Equity: Common shareholders and option holders

Simple Example

Company ABC sells for $10 million with the following capital structure:

$2 million in senior debt
$3 million in preferred equity (1x liquidation preference)
$5 million value remaining for common shareholders

Distribution:

Senior debt holders: $2 million (fully paid)
Preferred shareholders: $3 million (fully paid)
Common shareholders: $5 million remaining

Preferred Stock Liquidation Preferences

Non-Participating Preferred

Preferred shareholders choose between their liquidation preference OR their pro rata share:

Low Exit Values: Take liquidation preference (better option)
High Exit Values: Convert to common and take pro rata share
Breakeven Point: Value at which both options are equal

Participating Preferred

Preferred shareholders get their liquidation preference AND participate in remaining proceeds:

Double Dip: Get preference first, then pro rata share of remainder
Capped Participation: Participation limited to certain multiple
Investor Friendly: Generally favors preferred investors over common

Multiple Liquidation Preferences

Some preferred shares have multiples (2x, 3x, etc.):

Preferred shareholders get multiple of their investment before others
Higher multiples provide more downside protection
Common in down markets or distressed situations

Fund Waterfall Structures

European Waterfall

Deal-by-deal carry calculation:

Return limited partner capital contribution for each deal
Pay preferred return (hurdle rate) on that deal
Catch-up to general partner
Split remaining proceeds per carry terms

American Waterfall

Aggregate fund-level calculation:

Return all limited partner capital contributions
Pay preferred return on all invested capital
Catch-up to general partner
Split remaining proceeds per carry terms

Key Differences

Timing: European pays GP earlier, American later
Risk: European has clawback risk, American has delayed gratification
LP Preference: LPs generally prefer American waterfall

Calculating Waterfall Returns

Detailed Example: Venture Investment

Investment terms:

$5M Series A investment at $10M post-money valuation
50% ownership to Series A investors (preferred)
1x non-participating liquidation preference
50% ownership to founders/employees (common)

Exit Scenario Analysis:

$5M Exit (At Investment Amount):

Preferred: $5M (takes liquidation preference)
Common: $0

$20M Exit (2x Investment):

Preferred: $10M (converts to common for 50% of $20M)
Common: $10M (50% of $20M)

$10M Exit (Breakeven Point):

Preferred: $5M (either liquidation preference or 50% of $10M)
Common: $5M

Impact on Investment Decisions

For Investors

Downside Protection: Higher liquidation preferences provide safety
Upside Participation: Understand conversion thresholds
Valuation Sensitivity: Waterfall affects return sensitivity to valuation
Follow-on Decisions: Consider dilution impact on waterfall position

For Companies/Founders

Valuation Impact: Higher liquidation preferences reduce effective valuation
Motivation: Understand what exit values create founder value
Future Rounds: Consider cumulative impact of preferences
Exit Strategy: Structure exits to optimize for all stakeholders

Complex Waterfall Scenarios

Multiple Preferred Series

When companies have multiple funding rounds:

Seniority: Later series typically senior to earlier series
Stacking: Each series gets its preference before lower priorities
Conversion Decisions: Each series decides independently
Complexity: Multiple conversion points and scenarios

Anti-Dilution Adjustments

Down rounds can trigger anti-dilution provisions
Weighted average adjustments change conversion ratios
Full ratchet provisions provide maximum protection
Impacts overall waterfall distribution

Carve-Outs and Exceptions

Management Carve-Outs: Portion reserved for management team
Option Pool: Employee stock options participate differently
Founder Preferences: Sometimes founders get special treatment

Modeling Waterfall Returns

Key Variables to Model

Exit Valuation Range: Multiple scenarios from downside to upside
Liquidation Preferences: Amount and multiples for each series
Participation Rights: Participating vs. non-participating preferences
Conversion Ratios: Share counts for each class
Option Pool Size: Dilution from employee equity

Modeling Tools

Excel or Google Sheets with scenario analysis
Specialized cap table software (Carta, Pulley, etc.)
Monte Carlo simulations for probability distributions
Sensitivity analysis for key variables

Best Practices

For All Stakeholders:

Model Scenarios: Understand returns under various exit values
Seek Clarity: Ensure all parties understand the waterfall structure
Document Thoroughly: Clear legal documentation prevents disputes
Consider Incentives: Ensure structure aligns all parties' interests
Plan for Success: Structure should work for various exit scenarios

Conclusion

Waterfall distributions are fundamental to understanding investment returns in private markets. Whether you're an investor evaluating an opportunity or a company raising capital, understanding how proceeds will be distributed in various exit scenarios is crucial for making informed decisions.

The key is to model different scenarios, understand the incentives created by the waterfall structure, and ensure that all parties' interests are appropriately aligned. While waterfalls can be complex, particularly with multiple rounds and varying terms, careful analysis and clear documentation help ensure successful outcomes for all stakeholders.