The Waterfall Order
Exit proceeds are distributed in a strict priority sequence. Each tier is paid in full before the next tier receives anything. The standard order:
1. Transaction costs: legal fees, banker fees, escrow holdbacks. Typically 2–5% of gross proceeds. 2. Secured debt: any loans secured against company assets (venture debt, working capital lines, equipment finance). Paid at face value plus accrued interest and any prepayment penalties. 3. Unsecured debt: trade payables, unsecured loans, tax liabilities. Paid at face value. 4. Liquidation preference tiers (by seniority): preferred classes paid in order of seniority. Within each tier, holders take their preference amount (multiple × original investment) before the next tier sees anything. Pari passu tiers split available proceeds pro-rata. 5. Participating preferred overhang: participating preferred classes that have already received their preference now also share in the remaining common pool, in proportion to their as-converted ownership. 6. Common shareholders: founders, employees who have exercised options, common-class angel investors. Split whatever remains pro-rata to common ownership.
The waterfall is mechanical. Once the SHA is signed and the exit price is fixed, the payout to each holder is determined by formula. The only judgement call is whether non-participating preferred holders convert to common — which they do when conversion pays more than preference.
Worked Example — €15M Exit
Cap table at exit: • Seed Note: €500K principal + €100K accrued interest = €600K, senior to all preferred • Series A Preferred: €5M invested for 25%, 1× non-participating • Series B Preferred: €8M invested for 40%, 1× participating capped at 3× • Common (founders + employees + ESOP): 35%
Exit price: €15M cash. No debt other than the Seed Note.
Waterfall:
Tier 1 — Transaction costs: assume €750K (5%). Net for distribution = €14.25M.
Tier 2 — Seed Note: €600K (paid at face + interest). Remaining = €13.65M.
Tier 3a — Series B Preferred (senior, participating capped): • Preference amount = €8M (1× of €8M invested). • Pay €8M. Remaining for further waterfall = €5.65M.
Tier 3b — Series A Preferred (junior): • Preference amount = €5M. • Pay €5M. Remaining for common pool = €0.65M.
Tier 4 — Participating preferred overhang: • Series B participates in the remaining pool pro-rata on as-converted basis. • Series B's as-converted share of common + preferred (excluding Series B preference) = 40% / (40% + 35%) = 53.3%. • Series B share of €0.65M = €347K (subject to 3× cap check). • Series B total = €8M preference + €347K participation = €8.35M. Cap = 3× €8M = €24M. Under cap, so participation continues.
Tier 5 — Common: • Common pool = €0.65M − €347K = €303K. • Common holds 35% of total. Founders + employees + ESOP split €303K pro-rata to their common holdings.
Total payouts: • Seed Note: €600K • Series A Preferred: €5M (took preference — would have received only 25% × €15M = €3.75M as common; preference is better) • Series B Preferred: €8.35M • Common (founders + employees): €303K combined • Costs: €750K
Sum: €15M ✓
The founders and employees collectively receive €303K from a €15M headline exit. The liquidation preference stack absorbed €13.6M of the €15M. This is the math every founder needs to internalise before signing the next term sheet.
Conversion Decision Math
Each preferred class faces a binary choice at exit: take the liquidation preference, or convert to common and take pro-rata of the entire exit. The rule is simple: convert if pro-rata exceeds preference.
Non-participating: convert if (ownership % × exit price) > preference amount. Participating capped: continue participating until (preference + participation) > cap; above cap, convert. Participating uncapped: never convert.
The 'conversion point' is the exit price at which the decision flips. For a 25% holder with €5M preference (1× non-participating): conversion point = €5M / 25% = €20M. Below €20M, take preference. Above €20M, convert.
The conversion point matters strategically because it tells you where investor and founder incentives align. Below the conversion point, the investor wants the highest exit that still pays their preference — they may prefer a quick sale at €15M over waiting for €25M. Above the conversion point, investor and founder incentives align — both want the highest possible exit.
Senior vs. Pari Passu Preference Stacks
Two main structures for ordering preferred classes:
Senior (stacked): later rounds rank ahead of earlier rounds. Series B paid before Series A, which is paid before Seed. Common at growth-stage companies with multiple rounds.
Pari passu: all preferred classes rank equally. Series A and Series B share available proceeds proportionally to their preference amounts. Less common but more founder-friendly because it prevents the most recent round from absorbing all available proceeds in a mid-sized exit.
Hybrid: 'pari passu within tiers' — Seed and Series A pari passu (older 'venture' tier), Series B and Series C pari passu (newer 'growth' tier), with growth senior to venture. Increasingly common at Series C and beyond.
The stack structure can change the founder payout at exit by 30–50%. Push for pari passu at Series A; expect to lose this at Series B when the new lead insists on senior preference.
Special Cases: Earn-Outs, Escrow, Vesting Acceleration
Earn-outs: a portion of the exit price is contingent on post-close performance (typically 10–25% of gross proceeds over 12–36 months). The earn-out is paid through the same waterfall but on a deferred basis. Common in strategic acquisitions where the acquirer wants to lock in continued performance.
Escrow holdbacks: typically 10–15% of gross proceeds held in escrow for 12–24 months to cover potential indemnity claims. Paid through the same waterfall after release. Founders should model the post-escrow payout, not the headline exit price.
Vesting acceleration: SHA usually provides single-trigger (vesting accelerates on change of control) or double-trigger (vesting accelerates on change of control AND termination within 12 months) acceleration. Single-trigger founder-friendly; double-trigger investor-friendly. Acceleration affects ESOP and unvested founder shares — these become eligible for the waterfall on the same basis as vested shares.
Acquihire restructuring: in distressed acquihires where the exit price is below the preference stack, the acquirer often allocates a separate 'retention package' to key employees and founders, paid outside the waterfall. This is the only money founders receive in a sub-preference exit and should be negotiated as a condition of the deal.
How CAPLINK Runs the Waterfall
CAPLINK's waterfall analyzer computes the full payout for every holder at every exit price between €0 and €1B+. The output includes: payout per holder by tier, conversion decisions per preferred class, participation cap binding analysis, common-pool residual, and the per-share payout for founders and employees.
The same model handles earn-outs, escrow holdbacks, vesting acceleration scenarios, and tax considerations per jurisdiction. Used in due diligence, founder secondary planning, and pre-term-sheet modelling to see exactly how a proposed clause changes the founder payout at every exit price.
Read [liquidation preference](/captable/liquidation-preference) for the preference mechanics, [participating preferred](/captable/participating-preferred) for the participation rules, [drag-along and tag-along](/captable/drag-along-tag-along) for the consent procedures that trigger the waterfall, and [shareholder agreements](/captable/shareholder-agreements) for the SHA-level framework.