Waterfall Analysis

What is a waterfall analysis?

Waterfall analysis (German: Erlöswasserfall, Erlösverteilungsrechnung) denotes the calculation of how proceeds from a company sale, liquidation or an equivalent event are distributed in stages to creditors, investors, founders and employees. Also in use are exit waterfall and liquidation waterfall. The image of a waterfall describes the order of priority: like water that first fills one basin before overflowing into the next, each tier is served in full before the proceeds flow on to the next.

The calculation combines three foundations. The first is the cap table, the ownership table with all shares and share-like rights such as virtual shares, options and convertible loans. The second are the proceeds distribution rules from the shareholders' agreement and the articles of association, above all the investors' priority rights (liquidation preferences). The third is the purchase price mechanism of the company purchase agreement, which fixes how the agreed price becomes the amount paid out. The calculation is needed above all in two situations. Before a term sheet is signed, it tests new preferences across many conceivable sale prices. On exit, it distributes the actual proceeds to the cent and is transferred into a payment schedule.

The tiers of the proceeds waterfall

The starting point is the purchase price for the company, not the amount that reaches the shareholders.

Formula: distributable proceeds = enterprise value minus financial liabilities and debt-like items plus cash and cash equivalents minus transaction costs

The calculation generally runs through five tiers:

1. From enterprise value to equity value: From the value of the operating business (enterprise value), financial liabilities and debt-like items are deducted and cash and cash equivalents are added. This reconciliation is called the equity bridge; its result is the equity value, the value of all shares.
2. Transaction costs: fees for advisers, law firms and banks, to the extent borne by the company or out of the proceeds.
3. Instruments between debt and equity: shareholder loans not already deducted, and convertible loans. Depending on the contract, these are repaid or converted before the exit and then take part in the following tiers.
4. Preferences: servicing of the liquidation preferences in their agreed order of priority.
5. Residual proceeds: distribution among ordinary shares, among preferred shares whose pro rata share exceeds the priority, and among virtual shares under the participation plan.

Before the preference tier there is sometimes a portion of proceeds reserved in advance for management (management carve-out), which is meant to secure the team's cooperation in weak sale scenarios. It must be modelled as a separate tier.

Order of priority and conversion decisions

Stacked ranking and pari passu

How the preferences of several rounds stand in relation to one another determines the form of the fourth tier. With stacked ranking, each round forms its own tier, usually with the most recent round at the top. An earlier round then receives something only when the later ones are served in full. With pari passu (Latin for "with equal step"), all rounds share one tier. If the proceeds are not enough, each round receives the same percentage of its preference amount. Hybrid forms group individual rounds into ranking groups.

Conversion decisions

With creditable preferences (non-participating), it must be checked for each series whether the priority or the pro rata share is higher. The decisions depend on one another, because a series that takes its priority drops out of the pro rata distribution and thereby increases the others' share of the residual proceeds. The calculation is therefore carried out step by step: first all series take their priority, then series by series it is checked whether the pro rata share would be more favourable, until no decision changes any more. Non-creditable (participating) preferences receive priority and pro rata share, where applicable up to an agreed cap.

Employee programmes and later purchase price payments

Virtual shares are usually measured by the proceeds per ordinary share, which in turn falls as they are paid out. The calculation is therefore circular. In practice, the virtual shares are therefore included in the last tier like ordinary shares. The company pays out the amount so determined through payroll, and in the purchase agreement it is deducted from the purchase price as a debt-like item. How many virtual shares actually participate is determined by vesting, acceleration rules for the case of a sale, and base prices.

Purchase price components that flow only later, for example from an earn-out or a retention in an escrow account, are generally distributed cumulatively. For each payment, the waterfall is recalculated with the total proceeds that have flowed up to that point. Once the preferences from the first payment are covered, later payments flow mainly to the ordinary shares. Founders and team thus bear the risk of missing subsequent payments disproportionately.

Waterfall analysis in funding rounds, due diligence and exit

Before a funding round, the analysis shows in which range of possible sale prices the preference structure determines the founders' result. A curve across many proceeds is informative, from the sum of all preferences to a multiple of the new post-money valuation, not a single point. In this way it can be quantified what a difference in multiple, participation or ranking costs at realistic exit values.

In due diligence, acquirers and new investors reconcile the model with the contract texts. On exit, the waterfall becomes the payment schedule (funds flow), which the law firms prepare for closing and the sellers approve. It states, for each shareholder and each holder of virtual shares, the amount, the payment route and any retentions.

Worked example: waterfall analysis with Series A and Series B

A GmbH (German limited liability company) has the following fully diluted ownership structure, which includes all shares including the virtual ones: founders 50%, Series A 20% with an investment of EUR 5 million, Series B 20% with an investment of EUR 15 million, virtual shares 10%. The virtual shares are fully vested and, for simplicity, have no base price. Both series have a simple creditable (non-participating) preference, the Series B ranking ahead of the Series A. The amounts relate to the equity value after deduction of transaction costs.

• Proceeds EUR 18 million: The Series B receives its priority of EUR 15 million. EUR 3 million remains for the Series A; its priority of EUR 5 million is only partly covered. Founders and virtual shares receive nothing. With pari passu ranking, the EUR 18 million would be divided in the ratio 15 to 5: EUR 13.5 million for the Series B, EUR 4.5 million for the Series A.
• Proceeds EUR 55 million: The pro rata share of the Series B would give 20% of EUR 55 million = EUR 11 million, so it takes its priority of EUR 15 million. The remaining EUR 40 million is distributed among the remaining 80% of the shares. The Series A receives 20/80 of EUR 40 million = EUR 10 million and thus more than its priority. The founders receive 50/80 of EUR 40 million = EUR 25 million, the virtual shares 10/80 = EUR 5 million.
• Proceeds EUR 150 million: Both pro rata shares exceed the priority (EUR 30 million each compared with EUR 15 million and EUR 5 million). Distribution is pro rata: founders EUR 75 million, Series A and Series B EUR 30 million each, virtual shares EUR 15 million.

The founders thus receive 0%, around 45% and 50% of the respective proceeds. Up to EUR 75 million, the preference structure therefore co-determines their result; only above that does the pro rata share alone apply. The conversion threshold of the Series A is EUR 35 million: EUR 15 million for the Series B plus EUR 5 million divided by its 25% share of the residual proceeds. The Series B switches to the pro rata share only from EUR 75 million (EUR 15 million divided by 20%). In the EUR 55 million scenario, the amount for the virtual shares counts as a debt-like item. The acquirer pays EUR 50 million to the shareholders (EUR 15 million plus EUR 10 million plus EUR 25 million), and the company pays EUR 5 million to the employees.

Distinctions: waterfall analysis, cap table and waterfall chart

• Cap table: the inventory of shareholdings. The waterfall analysis builds on it and converts it into payments.
• Liquidation preference: a single distribution rule. The waterfall applies all rules together to a particular amount of proceeds.
• Business valuation: determines the value of the whole. The waterfall analysis distributes this value and says nothing about how high it is.
• Waterfall chart: a chart form that bridges a starting figure to an end figure via additions and deductions, for example from enterprise value to equity value. It can present the result of a waterfall analysis but is not itself a distribution calculation.
• Distribution waterfall in funds and real estate projects: regulates the distribution between investors and sponsor, usually in the sequence return of capital, preferred return (hurdle rate), catch-up and profit share (carried interest). The logic of the tiers is the same, the participants are different.

Common mistakes

• Purchase price confused with distributable proceeds. Without deducting debt, debt-like items and costs, every distribution comes out too high, most of all for the ordinary shares.
• Percentages not fully diluted. If virtual shares, promised options or loans to be converted are left out, the percentages of the last tier are wrong.
• Conversion decisions checked individually. Anyone who calculates each series in isolation overlooks that the thresholds shift one another.
• Later payments treated as immediate. Earn-out and retentions flow mainly to the ordinary shares once the preferences are covered and have to be valued with their risk.
• Interest and conversion discounts forgotten. Preferences that bear interest and convertible loans with a discount change the waterfall every month.
• Model not reconciled with the contracts. A table that departs from the articles of association and the shareholders' agreement leads to renegotiation among the shareholders at exit.

Frequently asked questions

Who prepares the waterfall analysis?

In the funding round, usually the company's finance function or an adviser, often coordinated with the lead investor. On exit, the sellers' law firms prepare the payment schedule on this basis, which all sellers approve.

When should a waterfall analysis be prepared?

At the latest before signing a term sheet that introduces new preferences. After that, it is updated with each round, each conversion and each change to the participation programme, so that it is available without delay in the sale process.

Can a waterfall analysis be prepared in Excel?

Yes, a spreadsheet is enough for most structures. Three sheets are usual: the fully diluted cap table, the preferences per series and a distribution calculation. The latter runs through, for a range of proceeds, from the equity bridge to the residual proceeds. The conversion decisions are checked step by step until none changes any more. With many series, caps and preferences that bear interest, a separate check of the formulas against the contract texts is advisable.

What does a waterfall analysis show in restructuring?

It shows what amount each group of creditors and each group of shareholders would receive without a restructuring plan, usually on a sale of the business as a whole, and compares it with the result of the plan. For an insolvency plan and a restructuring plan under the German Corporate Stabilisation and Restructuring Act (StaRUG), such a comparative calculation is mandatory. It is meant to show that no group is worse off under the plan and is the basis for overriding dissenting groups (cramdown).

Why do founders sometimes receive less than their percentage despite a high sale price?

Because participating preferences, multiples or interest continue to apply even at high proceeds. With only simple non-participating preferences, the founders receive their full percentage as soon as the proceeds exceed the highest conversion threshold. This is usually at the post-money valuation of the last round, and after an earlier round at a reduced price (down round) also above it.

The Roemer Capital view

For us, the waterfall analysis is a fixed part of the financial model for a funding round. We map all series, convertible instruments and participation programmes and show founders and management how a proposed term sheet works across the whole range of realistic sale prices, not only at the hoped-for result.

In a company sale, we link the waterfall with the purchase price mechanism, retentions and earn-out before the payment schedule is prepared. The legal interpretation of the distribution clauses remains a matter for the law firms; we make sure that all parties negotiate with the same calculation.