The Venture Capital Blueprint: Waterfall Model

In earlier articles of the Venture Capital Blueprint series (link; link and link), we delved into the foundational frameworks of investment deals, sourcing, screening, and investment analysis. Although these articles provide a good overview of the approaches commonly used for investment analysis, the topic wouldn’t be complete without the final crucial element — waterfall modelling.

Regardless of the stage or segment, VC investing is always a high-risk, high-reward game, and unfortunately, not all investments pan out. To manage this risk, VCs use a set of rights granting them a preferred return in certain scenarios, employing a financial model known as the liquidation preference model or “Waterfall Model.” This model helps determine the distribution of returns among investors, founders, and other stakeholders during an exit event such as an acquisition or IPO.

In this article, we’ll dive into the intricacies of the Waterfall Model, exploring how it works, why it’s used, and its implications for investors and entrepreneurs.

What is the Waterfall Model?

The Waterfall Model outlines the sequence in which different classes of shareholders get paid during a liquidation event. The name “waterfall” is derived from the model’s hierarchical structure, where returns flow from the top (senior investors) down to the bottom (common shareholders).

First, let’s look at the key components and terms in the Waterfall Model:

Liquidation Preference: This clause ensures that preferred shareholders (usually investors) get paid before common shareholders. For example, a 1x liquidation preference means that preferred shareholders receive at least the amount they initially invested before any proceeds are distributed to common shareholders.

Participation Rights: These rights allow preferred shareholders to participate in the remaining proceeds after their liquidation preference has been paid. There are two types:

• Non-participating preferred: Preferred shareholders receive only their liquidation preference and do not participate further.
• Participating preferred: Preferred shareholders receive their liquidation preference and then share in the remaining proceeds alongside common shareholders.

Conversion Rights: Preferred shareholders often have the right to convert their shares into common stock, usually at a favourable rate. This is typically done if the conversion results in a higher payout than the liquidation preference.

Caps on Participation: Some agreements place a cap on the total amount that participating preferred shareholders can receive, ensuring that common shareholders still receive a fair share of the proceeds.

How these components work together

Although it might sound confusing, the industry-standard combination of these rights is usually quite straightforward: 1x non-participating liquidation preference and 1:1 conversion to common stock. This structure is fairly well-balanced and provides investors with downside protection without adding too much pressure on founders’ motivation.

In long-form legal documents (usually in the relevant clause of the Articles of Associations), the applied language would be that on a liquidity event, an investor is entitled to the greater of:

(i) The Preference Amount (which is 1x of the invested amount), and

(ii) The amount that would be received if the Investor’s Preferred Shares were converted into Ordinary Shares immediately prior to such distribution at a 1:1 rate.

In other words, if all goes well and the exit happens at a higher-than-initial-investment valuation, the investor will just get its share of the proceeds without any preferences. Otherwise, the investor will return 1x the investment in a priority order but won’t participate in further distributions, and founders will receive their share of the proceeds.

In practice, we sometimes see an additional interest (at e.g., GILT rate) applied on the Preference Amount. However, any further preferences provided to the investor (higher than 1x or participating liquidation preference) would signal a challenging position for the company at the moment of investment, and the next round investors will always have it flagged.

Both investors and founders should always keep in mind that by asking for and accepting ‘better than the market’ terms, they risk putting the company in a difficult position in subsequent rounds.

And don’t just take my word for it — the above language is based on the BVCA’s Model Documents for early-stage investments (accessible here — BVCA Model Documents), and overall logic is well-aligned with industry standards.

How the Waterfall Model Works

As we always do, let’s talk numbers.

As is customary in our Venture Capital Blueprint series, you can access an illustrative Waterfall Model template through this link.

Let’s assume that before the exit, the company has raised 4 investment rounds as follows:

• Seed: €15m invested at a €12m pre-money valuation;
• Series A: €45m invested at a €30m pre-money valuation;
• Series B: €12m invested at an €80m pre-money valuation;
• Series C: €30m invested at a €250m pre-money valuation.

Further assuming that (a) the company has been issuing additional options to motivate the team along the way and (b) each investor had market-standard 1x non-participating liquidation preference, after Series C the Cap Table of the company will be as follows.

Proceeds distribution will happen in reverse order: investors (starting from the later stage investors) will have a choice between 1x of their investment and pro-rata share of the proceeds; then the founders and options holders will get the remainder. Depending on the exit valuation, it will be as follows:

Scenario 1: If the exit value is below €48m (total investment amount), all investors will evoke their liquidation preferences. Those on top of the waterfall will get 1x (Investor 4), while founders and early investors will likely receive nothing.

Given that the last round the company raised in our hypothetical scenario was at a €250m valuation, something should have gone very wrong since Series C to exit at €35m. And fair or not, investors of the last round would always have the most protection against such unforeseen disruptions in negative scenarios to compensate for their lower upside in positive scenarios due to higher entry valuation.

Scenario 2: A €50m exit is a ‘borderline’ scenario where all investors will get 1x via their liquidation preferences, whereas the remaining €50m will be distributed among founders and options holders.

Scenario 3: When the exit valuation is high enough, earlier investors’ 1x liquidation preference won’t be a preferential option as their pro-rata share of the distributions will exceed the preference amount. As a result, at these levels, last-round investors are the least protected group, receiving just 1x of their investments while, e.g., Seed investors will be making 11.7x on the invested amount.

Scenario 4: In positive scenarios of exit at a valuation significantly above the latest round, there is no need for downside protection in the form of liquidation preference as it’s more beneficial for all investors to choose distributions.

Participating Liquidation Preferences: Although the model assumes non-participating liquidation preferences, which is market-standard in the majority of real-life cases, if some of those were participating, their holders, after getting 1x, would take part in further distribution pro-rata to shareholding, significantly changing the waterfall.

Comparing the same exit scenarios, it is evident that participating liquidation preferences (assuming all investors have them) would move the distribution towards later stage investors at the cost of earlier stage investors and founders. For example, in Scenario 3 (€250m exit), Series C investors will get almost 2 times more distributions: €51m [calculated as €30m + 10.7% x (€250m — €48m)] versus just €30m if their liquidation preferences were non-participating.

Implications of the Waterfall Model

The Waterfall Model is crucial for both investors and entrepreneurs to understand as it significantly impacts financial outcomes:

For Investors:

Risk Mitigation: The liquidation preference protects investors by ensuring they recover their initial investment before common shareholders receive any proceeds.

Incentives: Participating rights and conversion options can make the investment more attractive by offering upside potential beyond the initial investment.

For Entrepreneurs:

Dilution Awareness: Founders must be aware of how different investment terms can dilute their ownership and impact their share of the exit proceeds.

Negotiation: Understanding the Waterfall Model helps entrepreneurs negotiate better terms with investors, balancing the need for capital with the desire to retain a meaningful stake in their company.

The Waterfall Model is a fundamental tool in VC returns modeling, providing a structured approach to distributing exit proceeds. By understanding its components and implications, both investors and entrepreneurs can make informed decisions that align with their financial goals and risk tolerance.

In the ever-evolving world of venture capital, mastering the nuances of the Waterfall Model can be the key to maximising returns and achieving successful outcomes for all stakeholders involved.

The financial models described in our Venture Capital Blueprint Series (including this one) are accessible via this link. These are exemplary illustrations and function somewhat like a constructor that you can tailor for your purposes, but they are not plug-and-play templates. Please use them with care and remember: the real strength of financial modelling doesn’t solely reside in numerical data but rather in the strategic insights it provides.