A liquidation waterfall is a document which gives you an overview of who gets paid what and when. Most often, this will be an Excel sheet which contains the necessary details of your capitalization table and the distribution preference structure. For later stage firms who are well into their Series B or C, you may encounter tools like Carta or Astrella, which automatically handle the structuring details, and make it easier to adjust participants.
The ‘How’
The preparation process starts with a comprehensive review of all relevant documentation. Gather your investment agreements, stock purchase agreements, and option plans. These documents contain the crucial details about ownership stakes and special rights that form the foundation of your waterfall structure. Create a detailed Excel or Google Sheets spreadsheet that captures not only the basic ownership percentages, but also the specific terms that affect payout priority and amounts.
Understanding the payout sequence is fundamental to maintaining an accurate waterfall. The typical structure begins with secured creditors (your long-term debt lenders), followed by preferred shareholders (your Series X investors) with their specific rights and preferences. After that comes the conversion analysis for preferred shares, determining whether conversion to common stock would be more advantageous for those shareholders. The final distribution goes to common shareholders. Each level may have distinct multipliers or caps that need careful documentation.
The ‘When’
Your liquidation waterfall needs regular maintenance to stay accurate and useful. The minimum requirement is an annual review and update, but more importantly, you should revise it whenever there’s movement on your capitalization table. This includes bringing on new investors, employees exercising their stock options, or existing shareholders selling their positions.
The ‘Gotchas’
While maintaining your waterfall, it’s essential to partner with your legal counsel. They can provide valuable insight into contractual nuances that might affect the distribution structure. As your capitalization table deepens and more key personnel are onboarded for incentive plans, consider investing in specialized waterfall management software to streamline this process and reduce potential errors.
Pay particular attention to provisions that can significantly impact your waterfall structure. Anti-dilution clauses and down rounds can substantially alter the distribution of proceeds in various exit scenarios. Regular maintenance helps you understand these dynamics and prevents unexpected complications when you need to rely on this document.
A well-maintained liquidation waterfall serves as a reliable guide for understanding your company’s obligations and stakeholder expectations. This understanding becomes particularly valuable during fundraising rounds, strategic planning, and exit discussions. It also helps us plan better for your next round or incentive planning strategy!
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