Understanding Waterfall Diagrams
I posted recently on the dangers of getting too hung up on pre-money valuation and promised to write a post on the different types of equity securities and the importance of creating a waterfall diagram.
First I want to touch on a couple of other key economic terms you should understand:
Dividends often get overlooked. Many venture financing rounds will include dividends that continue to accrue and get paid in the event of a liquidation (i.e. sale or winding down of the company). In other words, your investors’ liquidation preference grows by X% every year. Which brings me to:
Liquidation preference means that investors get their money back first. A 1X preference is most common (i.e. the investor gets his/her initial investment back before the holders of common stock receive anything). As mentioned above, accrued dividends are typically treated as part of the liquidation preference and paid before common shareholders receive anything.
In rare scenarios, investors will require a 2X or greater liquidation preference, where they receive 2X (or 3X or 4X) their initial investment before any proceeds flow to the junior classes of stock.
As you layer on multiple classes of preferred stock (Series A, Series B, Series C, etc.), the most recent round usually has the most senior liquidation preference. Series C gets paid before Series B, Series A, and Common; Series B gets paid before Series A and Common; Series A gets paid before Common.
Now, on to the bulk of the post:
Type of Security
Let’s explore the four types of stock we most commonly encounter in venture deals. (Actually, I almost never see common stock deals, but it helps to illustrate the point). To keep the math simple, assume our sample company raised a single round of financing: a $5M Series A with a $15M post-money valuation. So the common shareholders own 66.6% of the company on a fully-diluted basis and the Series A investors own 33.3%. Assume the preferred shareholders have a 1X liquidation preference. Dividends were ignored for simplicity.
Common stock is simple to understand. Everyone is on equal footing and the proceeds are split up evenly based on percentage ownership. In this case, when the company is sold the investors get 33.3% ($5M/$15M) and the Founders get 66.6%.
The diagram below is a basic waterfall diagram. The x-axis represents the total liquidation value of the company. The y-axis is the amount paid to a given class of stock at a given liquidation value. In this example, if the company is sold for $36M, the Series A shareholders receive $12M and the common shareholders receive $24M.
Convertible Preferred Stock
Convertible Preferred stock gives the investor a choice: take the liquidation preference or convert to common stock and take the proceeds that common stock would receive. The investor will choose whichever of those two options yields the greater return. In other words, the investor will take his/her liquidation preference until:
Fully Diluted Ownership % * Total Liquidation Value > Liquidation Preference
In this particular example, that transition point occurs when total liquidation value equals $15M (i.e. 33.3% * $15M > $5M). If the Series A shareholders take the liquidation preference, the common shareholders don’t receive any proceeds until after the full ($5M) preference is paid.
Participating Preferred Stock
In the case of Participating Preferred Stock, there is no choice. The investor gets the best of both worlds. The investor receives her liquidation preference then shares the remaining proceeds as if her stock had converted to common.
In this case, the investor gets the first $5M to satisfy her liquidation preference, and the remainder is split with 66.6% going to the common shareholders and 33.3% going to the Series A shareholders.
Hopefully it’s clear from the charts that participating preferred is more favorable to Investors and thus, less favorable to the Founders.
Participating Preferred Stock with a Cap
Participating preferred with a cap is similar to Participating Preferred; however, the participating proceeds are capped at some multiple of invested capital. In other words, the investor can receive her liquidation preference and participate with common, but only until her proceeds reach the cap. At some point, it will be more advantageous for her to convert her shares to common stock since she’ll receive more than the capped amount. Specifically, the investor will convert to common when:
Fully Diluted Ownership % * Total Liquidation Amount > Cap * Amount Invested
Let’s assume a 3X cap. Then the transition happens when the Total Liquidation Amount equals $45M (i.e. 3 * ($5M / 33.3%)).
Laying all of the Founders’ proceeds lines on one chart you can see the key takeaway: Even though the fully-diluted percentage ownership of the Founders and Investors were identical in each of these cases, the distribution proceeds varies dramatically.
A few final thoughts
The astute reader may point out that the differences are only relevant for smaller liquidation values. For a very large exit, Convertible Preferred and Participating Preferred with Cap will convert to Common Stock. Furthermore, the impact of Participating Preferred is negligible: If the example company above exits for $1B, the common stockholders probably don’t care too much if they’re taking home 66.6% of $1B or 66.6% of $995M (after the $5M liquidation preference gets paid to the investor).
This is all true. But, no matter how optimistic we are, history tells us that only a handful of startups have huge exits. Most exits — if they happen at all — skew towards the smaller side. And in those cases these differences are important.
My example here is simple and only considered a single class of preferred stock. These calculations get ugly as you layer on multiple classes of preferred stock and get way beyond the scope of a blog post. I’m in the process of writing a simple program to calculate waterfalls for more complicated cases (dividends, multiple classes of stock, etc.) so that companies can plug in their capital structure and get a waterfall diagram. More on that in the near future.
In the meantime, if you’re looking for more information, Venture Capital and the Finance of Innovation by Andrew Merrick and Ayako Yasuda is an amazing reference that goes through lots of examples.