In the context of a company exit, the waterfall determines how money from an acquisition or sale is divided between investors and common shareholders. The process follows a strict hierarchy.
In the provided example, a company is sold for $50 million after having received $15 million in total investment. The Series A investor invested $10 million with a 1x liquidation preference and non-participating rights. The Series B investor invested $5 million with a 1x liquidation preference and participating rights.
The distribution follows three tiers:
Tier 1 – Liquidation Preferences:Investors receive their protected amounts first. Series A receives $10 million and Series B receives $5 million. This leaves $35 million remaining.
Tier 2 – Participation:Because Series B has participating rights, they are allowed to “double dip.” If Series B owns 10% of the company, they take an additional $3.5 million (10% of the remaining $35 million). This reduces the remaining balance to $31.5 million.
Tier 3 – Common Stock:Only after all investor rights are satisfied does the remainder go to founders and employees holding common stock. In this scenario, they receive $31.5 million.
This structure demonstrates why founders may receive little or nothing even in a seemingly successful exit. If the company had sold for only $15 million, the entire amount would have gone to investors in Tier 1, leaving the founders with $0.
The term “waterfall” is also used in Venture Capital fund economics. Here it defines how profits from successful investments are split between Limited Partners (LPs) and General Partners (GPs). The standard four-step process is:
Return of Capital: All proceeds go to LPs until they recover their initial investment.
Preferred Return / Hurdle Rate: LPs typically receive a guaranteed annual return (often 8%) before managers earn any bonus.
Catch-Up: Profits then go to the GPs until their share equals the agreed percentage.
Carried Interest: Remaining profits are split, commonly 80% to LPs and 20% to GPs. This 20% carry is the primary incentive for fund managers.
