Waterfall Modeling:
A complete guide

What is waterfall modeling?

Waterfall modeling is a financial exercise used by investors and their portfolio companies to determine how proceeds are distributed among equity holders during a liquidity event, such as an acquisition.

Venture capital and private equity investment firms typically build waterfall models to predict the value of returns for their portfolio company investments. These models can be based on a number of variables, including the type of equity held, the timing of a potential exit, and the valuation of each company at the time of exit. Upon a liquidity event, some unitholders in LLCs (or stockholders in corporations) may receive a larger return than others depending on the company’s valuation and liquidation structure; some may receive no return at all.

Most LLC operating agreements—or certificates of incorporation for C-corporations—define a clear pecking order for how different types of unitholders will be paid out in such an exit event. This payout structure is called waterfall analysis or an exit waterfall, because of how distributions “spill over” from one class of unitholder to the next, moving down the cap table.

The complexity of a particular waterfall model depends on a number of factors, but is strongly related to the complexity of a company’s cap table.

Simple waterfall modeling 

The waterfall for a company with a simple cap table—one in which all equity holders own the same type of equity, with no preferences for any holder—can be thought of as a fraction. The numerator of that fraction represents the exit value of the company after repayment of debt and other obligations (i.e. the equity value), while the denominator represents the number of outstanding units. 

For example, a simple cap table for an LLC would have no profits interests units (PIU) with a liquidation threshold greater than $0, no required return of capital contributions, and none of the liquidation rights and preferences that are typically associated with preferred units.

If we assume there are only 12 million ordinary units—or common stock for C-corporations—on an LLC’s cap table, and the equity value upon an exit is $1.5 billion, then the entire waterfall analysis in this example would be $1.5 billion divided by 12 million ordinary units, resulting in a payout of $125 per unit.

Most waterfall modeling is not this simple. We will introduce participating preferred units in the next example to demonstrate our first of seven levels of waterfall complexity. 

Throughout this paper, we will use an LLC cap table with units and unitholders. While all of the examples are also applicable to stockholders at corporations, reach out to us with any specific questions, or for a customized example.

Capitalization and rights and preferences

Capitalization

Let’s set the stage by introducing the cap table displayed in Exhibit A. (Note: For helpful definitions of the bolded terms throughout, check out the glossary, also available when you download the full white paper.) 

You’ll notice that 50% of the company’s capital structure is equally represented by Preferred and Preferred Prime unitholders. Preferred and Preferred Prime unitholders each hold six million units—12 million units total—and there are 24 million units outstanding.

For this example, we will assume Preferred unitholders contributed $150 million for their six million units ($25 per unit) and Preferred Prime unitholders contributed $300 million for their six million units ($50 per unit). The total capital contributions equal $450 million ($150 million + $300 million). We will assume that Ordinary unitholders did not contribute capital.

There are many explanations for why Preferred and Preferred Prime unitholders paid different amounts per unit, but more likely than not, Preferred Prime unitholders invested at a later stage in the company’s lifecycle (and when the company had a higher valuation) than Preferred unitholders, similar to investing in a Series A versus a Series Seed fundraising round.

Rights and preferences

We will assume that Preferred and Preferred Prime are both participating unitholders, also referred to as having “participation rights.” Participation rights allow these investors to receive their initial investments back first upon a liquidity event. 

Participating unitholders

After their capital contributions are returned, the participating unitholders will then share any remaining profits alongside the ordinary (common) unitholders, according to their proportional share. Remaining profits are often distributed pro rata, on an as-converted basis. This just means the distributions are proportional to the participating unitholder’s share of ownership if their preferred shares were converted into common shares.

Participation is more common in private equity than venture capital and provides an additional layer of security and potential upside for investors, ensuring they recover their initial investment and share in any additional profits.

Non-participation

The alternative to participation, or “non-participation,” declares that investors will receive the greater of either (1) their capital contribution, or (2) the amount they would receive if they converted their preferred units into ordinary units.

Participation rights are typically better for the investor because they give the unitholder more options to achieve the best possible payout. Participation affords the investor both (1) and (2), whereas non-participation affords either (1) or (2). With non-participation, if the company is successful, the investor will go with path (2) and convert into ordinary units for a greater upside. If the company is unsuccessful, the investor will go with path (1), and hopefully recoup their initial capital contribution, plus any required return embedded in the original shareholder agreement, if any.

Example 1: Participation

We will begin the participating preferred waterfall modeling with a practical example, which will continue for each component of the waterfall. This practical example (shown within the blue boxes) will only apply to the first example, which goes into greater depth than the others.

Exhibit B displays the waterfall analysis for the cap table in Exhibit A, assuming the company were to exit for an equity value of $1.5 billion. In other words, if the unitholders in Exhibit A were paid out $1.5 billion, then Exhibit B displays the order in which those unitholders would be paid per the company’s operating agreement.

Breakpoints

Each row marked by a “description” in the waterfall represents a breakpoint in the model. A new breakpoint is created whenever a payment is satisfied (for example, when all capital contributions have been returned), or a new payment is triggered (for example, a PIU’s threshold is cleared and in-the-money).

From, To, and Delta

Moving to the “from” and “to” columns, if the company exits for an equity value between $0 and $450 million (which is the total capital contribution), then $450 million (i.e. the “delta,” which is the difference between the “to” and the “from”) will be paid to satisfy the Preferred and Preferred Prime capital contributions. 

At this point, all capital contributions have been returned. Any remaining proceeds will be distributed to Ordinary, Preferred, and Preferred Prime unitholders, pro rata, as displayed by the “to” and “delta” in the second breakpoint.

Value in tier

The “value in tier” column represents the proceeds that are available to distribute within a particular breakpoint, with a lower bound of $0 if there is nothing available to distribute, and an upper bound equal to the Delta.

Given an equity value of $1.5 billion, and provided that $450 million of capital contributions are required to be returned at the beginning of the waterfall, the first breakpoint’s value in tier is $450 million. 

As stated earlier, all capital contributions were returned following the first breakpoint, so any remaining proceeds will be distributed to all units, pro rata, on an as-converted basis. Accordingly, given that $450 million of the $1.5 billion has already been repaid, $1.05 billion will be distributed to all units, pro rata, in the second breakpoint.

Percentage distributions

Moving to the right side of the “description” column, these percentages represent the percentage of the value in tier that is paid to each unit class in that breakpoint.

For example, Preferred unitholders have a capital contribution of $150 million, and Preferred Prime unitholders have a capital contribution of $300 million (as discussed earlier). Accordingly, of the $450 million capital contribution that must be repaid to Preferred and Preferred Prime unitholders, 33% ($150 million / $450 million) will go to Preferred unitholders, and 67% ($300 million / $450 million) will go to Preferred Prime unitholders.

The percentages associated with the repayment of capital contributions are called dollar-weighted percentages, because they are calculated based on the total dollar amount of capital contributions. While the dollar-weighted percentages only represent one breakpoint in this example, depending on the seniority of capital contributions they could represent a greater number of breakpoints in other examples. 

For instance, if the operating agreement required that Preferred Prime’s capital contributions were paid before Preferred’s capital contributions (i.e. stacked preferences), that would have warranted two breakpoints with dollar-weighted percentages. In Exhibit B above, Preferred and Preferred Prime units are pari-passu, meaning all preferred shareholders in a company have equal distribution rights during a liquidation event.

All percentages after the dollar-weighted percentages are called unit-weighted percentages, because they are calculated based on unit counts. These are typically calculated pro rata. 

For example, Preferred and Preferred Prime unitholders both have six million units, while Ordinary unitholders have 12 million units (as discussed earlier). Accordingly, of the 24 million units, 25% (six million / 24 million) each goes to Preferred and Preferred Prime unitholders, while the remaining 50% (12 million / 24 million) goes to Ordinary unitholders.

Dollar distributions

The dollar distributions—located below the percentage distributions—are simply the result of multiplying the value in tier by the percentage distribution for that corresponding breakpoint, as shown in Exhibit C.

Unit class value

The unit class value—located below the dollar distributions—represents the total payout per unit class in each breakpoint, as shown in Exhibit D below.

Per unit value

The per unit value—located below the unit class value—represents the unit class value divided by the number of units in that class, as shown in Exhibit E below.

You’ll notice that each Preferred unit is worth exactly $25 more than each Ordinary unit, and each Preferred Prime unit is worth exactly $50 more than each Ordinary unit. As noted earlier, participation rights allow investors to receive their capital contributions before participating alongside Ordinary unitholders. 

This means that on a per unit basis, participating preferred unitholders receive both their capital contribution, plus the amount they would have received if they had converted their holdings into Ordinary units. 

Download the Waterfall Modeling White Paper

That concludes our first in-depth example for complex waterfall modeling, which focused on participation rights. Want even more?

Fill out the form below to download the free, complete Waterfall Modeling White Paper, which includes six additional models:

1. Non-participation

2. Adjusted pro rata

3. Profits interests with a per unit threshold

4. Profits interest with an overall threshold

5. Profits interest with with a catch-up provision

6. Vesting based on MOIC

The full white paper also includes a glossary of 20+ key terms and quick links to our most popular tools for LLCs: the Exit Simulation template and Equity Blueprints for LLCs and PE firms.