Congratulations! You’ve founded a startup and are ready to raise venture capital (VC) funding. What’s next?

One of the most crucial aspects of your startup’s journey to an exit – whether through acquisition, IPO, or another liquidity event – is understanding how proceeds are distributed. This process, known as the “waterfall,” determines who gets paid and in what order based on different types of equity held by various stakeholders.

When selecting investors, the terms they offer are just as important as the check size. Choose investors whose terms align with the long-term success of the company you’ve worked so hard to build. Let’s break down the key concepts.

Understanding Common Stock vs. Preferred Stock

Before diving into the waterfall distribution, it’s essential to understand the two primary types of equity that stakeholders hold in a startup: common stock and preferred stock.

Common Stock

Common stock is typically held by founders, employees, and early team members. This type of equity represents ownership in the company but comes with fewer rights compared to preferred stock. Common stockholders are the last to be paid in a liquidity event, meaning they only receive proceeds after all other obligations are satisfied. However, common stock is highly valued for its potential upside if the company achieves significant growth.

Example: Employees often receive common stock or stock options as part of their compensation packages, aligning their success with the company’s long-term performance.

Preferred Stock

Preferred stock is primarily held by investors. It provides advantages and protections over common stock, such as priority in receiving payouts during a liquidity event. Preferred stockholders often negotiate specific terms, like liquidation preferences, anti-dilution rights, and voting privileges, to safeguard their investment.

For instance, a preferred stockholder with a 1x liquidation preference is guaranteed to receive their initial investment back before any proceeds are distributed to common shareholders. This added layer of security makes preferred stock an attractive option for investors, ensuring they benefit even in less-than-ideal exit scenarios.

Types of Liquidation Preferences

Liquidation preferences are a key feature of preferred shares. They dictate how much money investors receive before common shareholders are paid. Here are the three main types:

1. Non-Participating Liquidation Preference

Under a non-participating preference, investors are entitled to either their original investment amount (often referred to as the “1x liquidation preference”) or their pro-rata share of the remaining proceeds, but not both. They choose the greater of the two.

Example: If an investor puts $1M into your company with a 1x non-participating liquidation preference and your company sells for $10M, the investor will receive $1M. The remaining $9M will be distributed among common shareholders.

2. Fully Participating Liquidation Preference

Fully participating preferences allow investors to receive their original investment back first and then participate pro-rata in the remaining proceeds alongside common shareholders. This structure favors investors, as they effectively double-dip into the proceeds.

Example: Using the same $1M investment scenario, under a fully participating preference, the investor first takes $1M off the top. The remaining $9M is then split pro-rata among all shareholders, including the investor.

3. Capped Participation

Capped participation is a hybrid of the two. Investors receive their original investment and a pro-rata share of the remaining proceeds, but only up to a pre-agreed cap, such as 2x or 3x their original investment. Once the cap is reached, the remaining proceeds are allocated to common shareholders.

Example: If the investor’s cap is 2x their $1M investment, they will receive a maximum of $2M, even if their pro-rata share would otherwise entitle them to more.

How the Waterfall Analysis Works in Practice

When your startup reaches a liquidity event, the waterfall analysis is applied to determine how the proceeds are distributed.

Step 1: Pay Preferred Shareholders: Preferred shareholders are paid their liquidation preference first. Depending on the type of preference (non-participating, fully participating, or capped), they may receive additional distributions afterward.

Step 2: Allocate Remaining Proceeds: After preferred shareholders are satisfied, the remaining proceeds, if any, are distributed to common shareholders, including founders and employees holding stock or stock options.

Why Does This Matter?

Understanding the waterfall is critical for founders to set realistic expectations for their payout in an exit scenario, especially when managing a complex cap table. While raising capital, it’s easy to focus on valuation and funding amounts, but the terms of your investment—especially liquidation preferences—can significantly impact your financial outcome.

For example, a high liquidation preference or fully participating structure can leave little for common shareholders in a modest exit. On the other hand, maintaining a clean and simple cap table with reasonable terms can result in a more equitable distribution for everyone involved.

Conclusion 

Raising capital from a VC is an exciting milestone, but it’s just the beginning of understanding the waterfall impact on your company. Understanding the intricacies of equity distribution and liquidation preferences ensures you’re prepared for the journey ahead. Mastering the waterfall will equip you to make informed decisions and lead your company to a successful and fair exit for all stakeholders.

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