#229 VC Co. Cap Tables, Exit Waterfall Models

Understanding how profits cascade from investors to founders—and why it matters for your next big exit.

We’ve been thinking a lot about waterfalls!

Today we go deeper on VC company capitalization (cap) tables and exit waterfalls to understand how different investors in a company receive their proceeds in the event of an exit.

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Bridging the Concepts

There’s a difference between VC fund waterfalls and exit waterfalls:

• VC Fund Waterfalls (Post #228): Focus on the overall fund level, detailing how returns are split between LPs and GPs after the fund's expenses and hurdle rates are covered.

• Exit Waterfalls: Zoom in on the individual company level, explaining how proceeds from a portfolio company's exit (like an acquisition or IPO) are distributed among stakeholders, including investors, founders, and employees.

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Understanding Exit Waterfalls (Foresight)

When a company exits, whether through an acquisition or IPO, who gets what? That’s where the exit waterfall comes in. It’s essentially a liquidation analysis, ensuring that every shareholder—from founders to investors—knows their payout structure.

Taylor Davidson’s insights on exit waterfalls offer a structured way to model these distributions. Here are the three key steps:

1. Pre-distribution Cap Table – Outline the different classes of shareholders and their respective rights.

2. Determining Distribution Amount – Calculate how much is available to distribute after settling any outstanding obligations like debt or unconverted convertibles.

3. Allocating Proceeds – Decide who gets what based on investment terms and shareholder agreements.

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Preferred vs. Common Shareholders

If you’re new to this, one key distinction to understand is between preferred and common shareholders:

• Preferred Shareholders (usually investors) get priority in payout through:

  • Liquidity Preferences – They often have the right to get their money back before common shareholders receive anything.

  • Conversion Options – They can choose to convert their preferred shares into common shares if it results in a higher payout.

This structured payout process makes exit waterfalls feel like a cascading flow—each layer affecting how much trickles down to the next group of shareholders.

"The best way to think of modeling a liquidity distribution is that the proceeds from an exit are ‘flowing’ down through the classes of shareholders."

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Innovative Approach

What caught our eye about Foresight's documentation is its emphasis on using waterfall modeling as a strategic tool for companies themselves. Instead of just being a mechanism for funds and how companies can use waterfall modeling to:

• Understand the impact of financing scenarios – Different funding rounds come with varying terms. Waterfall modeling helps founders see how different scenarios play out.

• Negotiate better deals – A transparent model allows companies and investors to structure fairer agreements.

• Attract and retain talent – Employees often ask, “What’s my equity worth?” A clear exit waterfall helps them see the potential value of their options.

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The Devil is in the Details

Of course, the specific structure of an exit waterfall can be complex. Factors that influence the distribution include:

• Liquidation preferences: Some investors may have the right to receive a multiple of their investment before other shareholders get anything.

• Participation rights: Some preferred shareholders may participate in the remaining proceeds after receiving their initial investment back.

• Common stock vs. preferred stock: Common stockholders (typically founders and employees) usually get paid out after preferred stockholders.

• Option pools: A portion of the exit proceeds may be allocated to the employee option pool.

Building a detailed exit waterfall model requires careful attention to the company's capitalization table and the specific terms of each investment agreement.

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Understanding Waterfall Modeling (Carta)

Carta’s Waterfall Modeling: A complete guide also has a lot of good content on waterfall modeling. I have listed some below, but full post here (link).

Simple vs. Complex Waterfall Models

• Simple Waterfall Model: In scenarios where a company's capitalization table (cap table) is straightforward—meaning all equity holders own the same type of equity without any special preferences—the distribution is relatively simple. The total equity value upon exit is divided by the number of outstanding shares, providing an equal payout per share.​

• Complex Waterfall Model: Most companies, however, have intricate cap tables featuring various equity classes, each with distinct rights and preferences. In such cases, the waterfall model becomes more elaborate, accounting for factors like liquidation preferences, participation rights, and conversion rights. For instance, preferred shareholders might have clauses that allow them to receive their initial investment back first, followed by a share of the remaining proceeds alongside common shareholders.

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A Practical Example: Distributing Proceeds

Let’s make this real. Suppose a company exits at a $1.5 billion valuation. If preferred shareholders initially contributed $450 million, their capital gets returned first. After that, the remaining $1.05 billion is divided among the remaining shareholders based on their ownership structure.

As Carta explains in their guide on waterfall modeling:

"At this point, all capital contributions have been returned. Any remaining proceeds will be distributed to Ordinary, Preferred, and Preferred Prime unitholders, pro rata."

This breakdown illustrates how proceeds flow, ensuring every shareholder understands their position in the payout structure.

1. Initial Capital Contributions Returned

   • Preferred shareholders receive their initial investment of $450 million before common shareholders see any payout.

2. Remaining Proceeds Distribution

   • The remaining $1.05 billion is distributed among Ordinary, Preferred, and Preferred Prime unitholders based on their ownership structure.

Below is a chart illustrating the distribution process:

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Participating vs. Non-Participating Shareholders

Another nuance is the distinction between participating and non-participating preferred shareholders:

• Participating Preferred Shareholders – They get their initial investment back and a pro-rata share of the remaining proceeds.

• Non-Participating Shareholders – They must choose: either take their initial investment back or convert their preferred shares into common shares for a potentially larger payout.

Exit waterfalls are more than just financial models; they’re critical tools for both investors and operators to navigate exits strategically. By understanding how proceeds flow, companies can plan better, negotiate smarter, and ensure all stakeholders are aligned on outcomes.

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VC Fund Quarterly Financial Review Template

To make financial tracking easier, we've put together a VC Fund Quarterly Financial Review Template (screenshot below). This tool helps analyze cost differences and Fair Market Value (FMV) changes between quarters, ensuring transparency in portfolio performance.

We'll dive deeper into this on Tuesday, covering how to use it effectively. If you’d like access to this template and other premium VC tools and models, feel free to reach out!