An exit waterfall is the calculation showing exactly how proceeds from a sale or liquidation get distributed across every class of shareholder, in order, based on liquidation preferences, participation rights, and ownership percentage.
Preferred shareholders with liquidation preferences get paid first, in the order and amounts their preferences specify, and only after those are satisfied does anything flow down to common stock. Multiple rounds of preferred stock, each with its own preference terms, can stack in a specific order that isn't always obvious from looking at the cap table alone.
Running the actual waterfall math before a sale closes, not after, is the only way to know what a given exit price actually means for the founders and employees holding common stock. The headline sale price and what common shareholders walk away with can be two very different numbers once every preference ahead of them is paid out.
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