Meaning
Mathematical models illustrate the sequence and flow of proceeds to different classes of security holders during a liquidity event. The liquidity waterfall accounts for debt, liquidation preferences, accrued dividends and common stock to show exactly how much cash each person receives. This calculation is essential for understanding the actual value of an equity stake.
Distribution Order
Tiers of payment follow the seniority established in the corporate charter and the investor agreements.
Exit Calculation
Scenarios are run at different valuation points to see where the founders and employees begin to earn a return. A high preference stack means the exit price must reach a certain threshold before the common equity is worth more than zero. This model reveals the structural costs of the capital raised during the life of the company.
Tiered Payment
Allocation of the final dollar involves a step by step reduction of the remaining proceeds as each class of stock is satisfied. For the founder, the cost of a complex waterfall is the uncertainty of the final payout and the high capacity needed to negotiate terms that protect the common stock. This analysis shows the human cost of raising capital with aggressive preference terms.
Accurate modeling prevents surprises during the final distribution of assets.