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What is an exit waterfall?

When a company is sold, the price does not get split by ownership percentage. It flows down a fixed order, like water filling one basin before it spills into the next. That order is the exit waterfall.

Why the order matters

A cap table lists who owns what percentage of a company. It is a good description of ownership, and a poor predictor of what each owner receives in a sale. Investors who put money into a company usually negotiate the right to be paid back first. Founders and employees, who hold ordinary (common) shares, are paid from what is left. In a sale for a modest price, that difference can be the entire outcome.

The order of payment

1. Take off what is not for shareholders. The headline price is the enterprise value: the price of the whole business. Debt, transaction costs and other claims are paid first. What is left is the equity value, the amount shared among shareholders.
2. Pay the preferences, by rank. Preferred stock carries a liquidation preference, a right to receive a set amount before common. Rank decides the order: rank 1 is paid in full before rank 2 receives anything. Classes of equal rank are paid together, in proportion to what each is owed, if the money runs short.
3. Let each class choose. A preferred class either keeps its preference or converts to common if that pays more. A participating class takes its preference and then also shares in what is left.
4. Share what remains. Everything left is shared among all the common-equivalent shares: founders, employees, converted preferred, and options and warrants in the money.

The convert-or-keep decision

Take a non-participating preferred class. It has two choices, and picks the larger:

• Keep its preference, a fixed amount, usually what the investor put in.
• Convert to common, and receive its ownership percentage of the amount shared as common.

At a low price the fixed preference is bigger. As the price rises, the common share grows and eventually overtakes it. The price where the two are equal is a breakpoint.

A worked example

A company has 8,000,000 common shares held by the founders and 2,000,000 Series A preferred shares, bought for $10,000,000 ($5.00 a share). Series A owns 20% and has a 1x non-participating preference. There is no debt.

The breakpoint is $50M. Below it, Series A takes a larger share than its 20% ownership. Above it, exactly 20%. You can move this price yourself in the interactive example on the home page.

Options, SAFEs and debt

• Options and warrants are paid the difference between the share value and the strike price, and nothing if the share value is below the strike. They share in the residual only once they are in the money.
• SAFEs and convertible notes convert into shares at the better of a cap price and a discount price. In a low sale there may be too little to convert, and they are repaid their purchase amount after the preferred. See SAFEs in an exit.
• Debt comes off the price before any shareholder is paid.

This guide is general education, not legal, tax or investment advice. The rights of each class are set by the company's documents.