Example Waterfalls
A distribution waterfall is the mechanism that determines how proceeds from a sale or liquidation are allocated among the classes of investors in a multi-class capital structure. Understanding how a waterfall flows, tranche by tranche, is essential to understanding what any class of equity is actually worth.
How a Waterfall Starts
Before any equity holder receives proceeds, two deductions are made from the total sale price. First, working capital obligations such as payroll and accounts payable are settled. Second, all outstanding debt, including credit lines, property loans, and bank debt, is repaid. What remains after those deductions is the proceeds available to equity.
Before proceeds flow to any equity class, working capital and debt obligations are settled first. In this example, a $110 sale price yields $100 in proceeds available to equity after $2 in working capital and $8 in debt are deducted. Source: Deal Valuation, LLC.
The Five Tranches
Once proceeds are available to equity, they flow through five tranches in strict order of priority. Each tranche must be fully satisfied before the next receives anything.
Tranche 1:
Term Loans, Senior Non-Convertible Debt. Senior debt holders are paid first. These are the most secure creditors in the capital structure, backed by assets and holding the highest priority claim on proceeds.
Tranche 2:
Preferred Liquidation Preference. Preferred equity holders receive their liquidation preference next. The most recent round of preferred. For example, Series B holds a senior position over earlier rounds such as Series A. Liquidation preferences typically equal the original investment amount, sometimes plus accumulated dividends.
Tranche 3:
Common Stock Participates. Once all preferred liquidation preferences have been satisfied, common stock begins to participate. This is the breakpoint where founders, employees, and other common holders start receiving value from the proceeds.
Tranche 4:
Preferred Converts As the per share value of common stock reaches the preferred conversion price, preferred equity converts to common and participates pro rata in all remaining value above that threshold. This tranche only applies to convertible preferred; participating preferred has already been receiving proceeds since Tranche 2.
Tranche 5:
Options Exercise Options and warrants exercise at this stage if the per-share value of common exceeds their strike price. Options represent the most subordinate and highest-risk position in the waterfall and are the last to receive any proceeds.
A Worked Example
Using $100 in proceeds available to equity, here is how a typical multi-class structure distributes value. In this example, the preferred is convertible with no accumulation of dividends. Series B holds a senior liquidation preference over Series A.
As liquidation preferences are satisfied, class participation shifts across tranches. In this example, the total preferred liquidation preferences of $30 create the breakpoint for Tranche 3, where common stock begins participating. Source: Deal Valuation, LLC
Upturn vs. Downturns
One of the most important features of the preferred liquidation preference is what it does in a downturn. If the company sells for less than the total preferred liquidation preferences, common stockholders receive nothing; the preferred protection absorbs the loss. In an upturn, once the liquidation preferences are satisfied, preferred converts and shares in the upside with common. This asymmetric payoff is one of the primary reasons PE and VC investors structure deals with preferred equity rather than common equity.
The liquidation preference protects preferred holders in a downturn while still allowing participation in upside above the preference threshold. Common stockholders only benefit once all preferred stock’s preferences have been satisfied. Source: Deal Valuation, LLC.
Why Are STRUCTURES Getting More Complicated Gatherings
Real deals rarely look like a clean five-tranche waterfall. Multiple rounds of preferred, convertible notes, SAFEs, options pools, and side letters all add layers of complexity. Each additional instrument creates new breakpoints, new participation rules, and new interactions between classes. This is why a rigorous method like the Discounted Future Proceeds Method is necessary, as simple models cannot accurately allocate value across a truly complex capital structure.
Real multi-class capital structures are significantly more complex than a standard five-tranche waterfall. This example shows an actual structure valued using the Discounted Future Proceeds Method. Source: Deal Valuation, LLC.
What the Current Value Method Gets Wrong
The Current Value Method, one of three methods outlined by the AICPA, allocates value based on what each class would receive if the company were liquidated today. While straightforward, it fails to account for the time to a future sale, the required returns of each class, and the risk carried by each tranche. For any company that is not selling immediately, the Current Value Method produces allocations that do not reflect the economic reality of the capital structure. This is precisely the gap that the Discounted Future Proceeds Method is designed to fill.
The Current Value Method does not account for the time to sale or the different required returns of each equity class. For companies not selling immediately, it is generally not appropriate as a standalone method for multi-class equity allocation. Source: Deal Valuation, LLC.
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