Step-by-Step Methodology
Building a waterfall model proceeds in five steps. Skip any step and the output is unreliable.
Step 1 — Inventory all securities. List every share class (Common, each Preferred class), every debt instrument outstanding, every warrant, every convertible. For each, record: shareholder, original investment amount, original price per share, current share count, conversion ratio (after any anti-dilution adjustments), liquidation preference multiple, participation status (participating / non-participating), participation cap (if any), accrued dividends (if any), seniority rank.
Step 2 — Determine seniority ordering. Debt is always paid first (in seniority order within debt). Then preferred in the order defined by the shareholders' agreement — typically most-recent round first ('Series B is senior to Series A is senior to Seed') but sometimes pari passu (all preferred ranks equally). Then common.
Step 3 — Calculate the preference payment for each preferred class. Preference = multiple × original investment + accrued dividends. The total preference stack is the sum of all preferred preferences.
Step 4 — Determine conversion decisions per class. For each non-participating preferred class, calculate the conversion threshold: at what exit price does taking the preference equal taking pro-rata common? Below the threshold, take the preference. Above, convert to common.
Step 5 — Distribute proceeds tier by tier. Debt first. Then senior preferred (preference path). Then junior preferred. Then participating preferred secondary distribution. Then common (including converted preferred).
The output is a payout table showing each shareholder's net receipt and effective return multiple (cash-on-cash). The same waterfall executed across multiple exit prices produces a sensitivity table — the most useful output for board discussions about acquisition offers.
Cap Table for the Worked Examples
Four holder classes used throughout the three scenarios below:
• Seed Convertible Note: €500K invested, converted at Series A at the cap. Converted to 250,000 Series Seed Preferred at €2.00/share. 1× non-participating preference. Seniority rank: 3 (most junior preferred). • Series A: €4M invested at €2.00/share = 2,000,000 Series A Preferred. 1× non-participating preference. Seniority rank: 2. • Series B: €10M invested at €5.00/share = 2,000,000 Series B Preferred. 1× participating preferred capped at 3× return. Seniority rank: 1 (most senior). • Common: founders + employees + cancelled-options recipients = 4,500,000 Common shares.
Total fully diluted: 250,000 + 2,000,000 + 2,000,000 + 4,500,000 = 8,750,000 shares. Total preference stack: €0.5M + €4M + €10M = €14.5M. No debt outstanding. No accrued dividends. Straightforward worked case.
Scenario 1 — €5M Acqui-Hire
Exit price: €5M. Total proceeds available: €5M.
Step 1 — Pay debt: €0 outstanding. Remaining: €5M.
Step 2 — Senior preferred (Series B) preference path: preference = €10M, but only €5M is available. Series B takes €5M of preference; €5M of preference remains unpaid. Remaining: €0.
Step 3 — Series A preference: €0 available. Series A receives €0.
Step 4 — Series Seed preference: €0 available. Series Seed receives €0.
Step 5 — Common distribution: €0 available. Common receives €0.
Step 6 — Convert decision check. None of the non-participating classes would convert (conversion would yield even less than the partial preference they received). Series B does not convert because the participation right is on top of the preference, not in lieu of it.
Final payout: • Series B: €5M (vs. €10M invested = 0.5× return) • Series A: €0 (vs. €4M invested = 0× return) • Series Seed: €0 (vs. €0.5M invested = 0× return) • Common: €0 (founders + employees receive nothing)
This is the brutal acqui-hire scenario. The preference stack consumes everything; common receives zero. Founders walk away with whatever ongoing compensation is negotiated with the acquirer plus any retention grants. The €5M sale headline hides the reality that the founding team has lost their equity entirely.
Scenario 2 — €20M Trade Sale
Exit price: €20M. Total proceeds available: €20M.
Step 1 — Pay debt: €0. Remaining: €20M.
Step 2 — Senior preferred (Series B) preference path: preference = €10M. Series B takes €10M. Remaining: €10M.
Step 3 — Series A preference: €4M. Series A takes €4M. Remaining: €6M.
Step 4 — Series Seed preference: €0.5M. Series Seed takes €0.5M. Remaining: €5.5M.
Step 5 — Series B participation (the 'second dip' on participating preferred): Series B participates pro rata with common in the remaining proceeds, capped at 3× total return (€30M cap). Series B's pro-rata share of common-equivalent: 2,000,000 / (2,000,000 Series B + 4,500,000 Common) = 30.8%. Series B participation: 30.8% × €5.5M = €1.69M. Series B total so far: €10M + €1.69M = €11.69M (well under the €30M cap; participation is not capped out).
Step 6 — Common distribution of the rest: €5.5M - €1.69M = €3.81M distributed pro rata to common (4,500,000 / 6,500,000 of remaining = 69.2% basis). Common receives €3.81M.
Step 7 — Convert decision check. Series A non-participating: pro-rata at €20M = €4.57M; preference = €4M. Wait — pro-rata is higher than preference. Series A should convert.
Restart with Series A conversion: • Series A converts to 2,000,000 Common. Total Common-equivalent: 4,500,000 + 2,000,000 = 6,500,000. • Series B preference: €10M. Remaining: €10M. • Series Seed preference: €0.5M. Remaining: €9.5M. • Series B participation pro-rata: 2,000,000 / (2,000,000 + 6,500,000) = 23.5%. Participation: 23.5% × €9.5M = €2.23M. Series B total: €12.23M (under cap). • Remaining for common-equivalent: €9.5M - €2.23M = €7.27M. Distributed to 6,500,000 common (incl. converted A): per-share €1.12. - Series A converted: 2,000,000 × €1.12 = €2.24M. Worse than €4M preference. Series A should NOT convert.
Series A keeps preference. Final payout table: • Series B: €10M preference + €1.69M participation = €11.69M • Series A: €4M preference • Series Seed: €0.5M preference • Common (4,500,000): €3.81M total = €0.847/share
Founders + employees split €3.81M out of a €20M exit. The €14.5M preference stack consumed 72.5% of the exit. Series B's participation right consumed another €1.69M. Common received 19% of the exit despite owning 51% of the fully diluted cap table.
Scenario 3 — €80M Strategic Exit
Exit price: €80M. Total proceeds available: €80M.
Step 1 — Pay debt: €0. Remaining: €80M.
Step 2 — Convert decision pre-check. At €80M, every non-participating preferred is significantly better off converting. Check: • Series A: preference €4M, pro-rata if converted = 2M / 8.75M × €80M = €18.3M. Convert. • Series Seed: preference €0.5M, pro-rata if converted = 250K / 8.75M × €80M = €2.3M. Convert. • Series B: keeps participating preferred regardless (no conversion decision — participating preferred always takes both).
Step 3 — Series B preference: €10M. Remaining: €70M.
Step 4 — Series B participation pro-rata: Series B = 2M, Common (incl. converted A and Seed) = 4.5M + 2M + 250K = 6.75M. Series B's share: 2M / (2M + 6.75M) = 22.9%. Participation: 22.9% × €70M = €16.0M.
Step 5 — Series B total: €10M + €16.0M = €26.0M. Cap is 3× = €30M. Under cap, full participation applies.
Step 6 — Remaining €70M - €16.0M = €54M distributed to common-equivalent (6.75M shares) = €8.00/share. • Common: 4,500,000 × €8.00 = €36M • Series A (converted): 2,000,000 × €8.00 = €16M • Series Seed (converted): 250,000 × €8.00 = €2M
Final payout table: • Series B: €26M (vs. €10M invested = 2.6× return) • Series A: €16M (vs. €4M invested = 4.0× return) • Series Seed: €2M (vs. €0.5M invested = 4.0× return) • Common: €36M (founders + employees)
This is the upside scenario every founder is working toward. At €80M, all classes are paid in full and proportionally, the participation right has minor impact, and common captures the largest share. The conversion decision for Series A and Seed is the key mechanic — without it, they would receive their small preference amounts and leave most of the upside to common.
For a complete operational view of these mechanics, see [exit waterfall](/captable/exit-waterfall), [liquidation preference](/captable/liquidation-preference), [participating preferred](/captable/participating-preferred), [waterfall breakeven](/captable/waterfall-breakeven), and [preference stack](/captable/preference-stack).