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.