Understanding Cap Table Waterfalls: Analysis, Modeling, and Distribution

Not all shareholders are equal.

Investors typically negotiate special rights through preferred stock and liquidation preferences. These allow them to reclaim their investment and sometimes a multiple of it before common shareholders (founders/employees). 

A waterfall model determines the payout order, the amount each stakeholder receives, and what remains for other shareholders.

What is a waterfall analysis?

Waterfall modelling is a structured framework used to determine how exit proceeds are distributed among investors, founders, and employees. The term "waterfall" comes from the way funds flow down through multiple tiers. This ensures that certain stakeholders receive their payouts before others, based on pre-agreed terms.

How does waterfall modelling work?

A waterfall model prioritises payments during an exit event, such as an acquisition or IPO. Here’s a step-by-step breakdown of how it works:

Step 1: Defining the capital stack

A company's capital stack consists of two types of shareholders:

a. Preferred shareholders (investors): These include venture capitalists who hold preferred stock and typically have liquidation preferences that prioritise their payout.

b. Common shareholders (founders & employees): These stakeholders hold common stock and are paid only after preferred shareholders receive their due.

Step 2: Applying liquidation preference and multiplier

a. Liquidation preference: Investors with preferred shares have the right to be paid before common shareholders. The payout order depends on whether the preferences are pari passu (all preferred shareholders are paid together) or stacked (later-stage investors are paid first).

Pari-passu vs. stacked preferences

In some cases, all preferred shareholders have the same payout priority, known as pari passu (Latin for "equal footing"). However, they may still have different liquidation multipliers, for example, some may have a 1x preference, while others have 2x.

In other cases, liquidation preferences are stacked, meaning certain investors are prioritised over others based on seniority. For instance, later-stage investors with stacked preferences receive their payouts first, before earlier investors receive their share.

b. Liquidation multiplier: Some preferred shareholders negotiate a multiplier on their liquidation preference. For example, with a 2x liquidation preference, an investor who put in $1 million would receive $2 million before any remaining proceeds are shared with other shareholders.

Step 3: Determining participation rights

Participation rights decide whether investors only receive their liquidation preference or if they also share in the remaining profits.

a. Participating preferred stock: Investors recover their initial investment first and then share in any additional proceeds alongside common shareholders proportional to their stake.

b. Non-participating preferred stock: Investors must choose between claiming their liquidation preference or converting their preferred shares to common stock and sharing in the profits, whichever yields a higher return.

Step 4: Distributing remaining proceeds to common shareholders

Once all preferred shareholders receive their liquidation preferences and any applicable participation rights, the remaining proceeds are distributed to common shareholders proportional to their ownership percentages.

Why do founders/companies need waterfall modelling?

Waterfall analysis isn’t just relevant at the time of an exit; it plays a crucial role in fundraising as well.

By modelling different investment scenarios in advance, companies can assess how new funding rounds impact ownership, investor returns, and payout structures.

For founders, waterfall modelling helps anticipate dilution, estimate potential payouts under various exit scenarios, and negotiate better investment terms. Without this analysis, they risk underestimating how much investors will take before they receive any proceeds, leading to unexpected financial outcomes.

From a company’s perspective, maintaining an up-to-date waterfall model allows management teams and investors to track the value of their holdings and ensure financial transparency.

FAQs

‍1. How does waterfall analysis affect equity distribution during a liquidity event?

Waterfall analysis simulates different exit scenarios to show how a company's proceeds will be distributed among shareholders, starting with those who have higher preferences (such as preferred stockholders) and moving down to those with lower or no preferences (such as common stockholders). This ensures a fair and transparent distribution based on the company's exit terms.

2. How do I model different exit scenarios using waterfall analysis?

Waterfall analysis can be modeled using Excel or specialized equity management platforms like EquityList. By adjusting the model to simulate different exit valuations, shareholders can see how varying sale prices impact their payouts.

3. Why is it important for founders to regularly update their cap table?

Regularly updating the cap table ensures that it accurately reflects ownership changes, new funding rounds, stock option exercises, and share transfers.