Article #9: The Distribution Waterfall
I remember reading an article in the newspaper about a recent exit of an Israeli start-up. The reporter commented on the ownership percentages of some of the shareholders, and added a table where he spread the deal value between them, accordingly. Big mistake. Huge J
In this article, and in the following ones, I will explain where the reporter erred, and will clarify what a distribution waterfall is. I will convey the importance of understanding how to properly read and analyze the distribution waterfall, and the crucial role it plays in your decision to invest, or to not invest in the startup.
Let’s start with the basics and go through the definitions step-by-step.
What is a Distribution Waterfall?
A distribution waterfall delineates the method by which capital gains are allocated between the shareholders in case of a liquidation event. The distribution waterfall defines the order and amounts in which distributions are allocated to the shareholders. The waterfall structure can be thought of as a series of pools that fill up with cash flow, and then once full, spill over all excess cash flow into additional pools.
Common Shares
These are the basic shares of the company. This is the ground where everybody starts from. The entrepreneurs receive common shares. The ESOP is eventually transferred to common shares.
Preferred Shares
These shares will be first in the queue when distributing cash in the case of a liquidation event. Distribution of cash for common shares can take place only after all of the preferred shares are paid. We will see that there are different types of preferred shares with different orders of distribution.
Order of Distribution
The method of preferred share distribution is LIFO (Last-In, First-Out). This means that the last investor in, is the first to receive cash against his preferred shares.
Participating / Non-Participating
From the preferred share types, non-participating preferred shares are first in the distribution order. These shareholders receive their full investment back (before payment is made to any other shareholder), and then, if needed, complete to their pro-rata share. Participating shares means that after receiving the cash invested, the shares then re-participate, pro-rata with the rest of the cash distribution.
Here is an example:
An investor invests $100K for 10% preferred participating shares in a start-up. The start-up was sold for $2M. The investor first receives his $100K. Then, he participates in the rest and receives his 10% of the remaining $1.9M, which is an additional $190K. In total, the investor in this scenario receives $290K.
Multiple
For these preferred shares, the investor receives a multiple on the investment amount before going to other shares. Staying with the same example, as in the previous paragraph, and using a multiple of 3the investor first receives 3 X $100K = $300K and the rest is distributed to the other shareholders.
Interest
The investor may request that his investment carry an annual interest rate. Keeping the same investment parameters, after 3 years with a 6% interest rate, the investor receives $119.1K before distributions are made to the other shareholders.
Anti-dilution
As explained in my previous articles, sometimes there are down rounds where the price per share is reduced. An anti-dilution mechanism is used for preferred shares to protect the price per share from being reduced. There are different types of anti-dilution mechanisms.
There are many and varied methods for defining preferred shares. In my next article, I will give an example demonstrating why, when you have preferred shares involved, the connection between ownership percentage and actual cash received is not trivial.
To great investing!
Ido
Disclosure: I am not a professional consultant. I wrote this article myself, and it expresses my own opinions.