Previously I discussed the importance of a company’s cap table. In addition to the importance of the cap table while the company is a going concern, it is critically important during the exit because it is a key tool in calculating the waterfall.
Simply put, the waterfall is the general term used to describe the method of distributing the cash (or other deal consideration) received when selling the company among various stockholders and other constituencies, most of which is dictated by the charter. The term “waterfall” is a useful metaphor for how exit value flows down through the company’s lenders and the various tiers of the cap table based on seniority of rights at exit. When a company is to be sold, the first question the lead investors ask is “how much do I get”, and the waterfall (typically an excel table) is tool to consolidate all of the requirements of the company’s obligations at an exit (in terms of debt instruments, bonus plans, and the charter) into a tool that tries to answer that question. Like cap tables, waterfalls can start off simple but can get very complex in a hurry. Waterfalls tend to be highly customized, so while this post will walk through the concepts and construction, an all-purpose example wouldn’t be broadly applicable.
The easiest example is a company with no debt and only a couple of common stockholders. In this situation, the entire purchase price for the company that is available to the stockholders would be allocated among the common stockholders pro rata based on the number of shares owned. A slight wrinkle would be if the company had some outstanding loans or other debt, such as a line of credit. Here the debt is usually required to be paid off from the purchase price, and then the remainder would be distributed as above.
The waterfall gets more complicated if there are one or more series of preferred stock. Suppose in addition to common stock the company has an outstanding series of preferred stock (call it “Series A”). To properly construct the waterfall, all of the rights and preferences of the Series A set forth in the company’s charter or other governing documents need to be accounted for. Usually, preferred stock will have a minimum return on a senior basis before any junior tiers (like common) get anything, such as the original purchase price per share (or a multiple thereof), called the “liquidation preference”. It will probably also have the right to convert into common stock, and might get to “participate” with the common stock in the residue of anything left over after the initial liquidation preference is dealt with. Furthermore, that participation might be capped at some multiple of the liquidation preference. Dividends may have been accruing on the Series A that will also need to be paid (these are usually baked into the concept of the “liquidation preference”).
It is apparent all of these variables can cause the waterfall to get tricky. Starting with the purchase price and deducting transaction expenses and amounts to be paid to creditors gives the “net consideration” to be distributed to stockholders. First, if dividends had been accruing on the Series A, they need to be allocated and the Series A’s liquidation preference needs to be taken into account. If the net consideration flowing into this first tier of the waterfall is greater than the liquidation preference, then the common stock will at least receive something in connection with the exit. If the Series A participates with the common stock, this would reduce the amount per share the common stock receives while increasing the amount per share the Series A receives. They might only participate with the common up to a certain threshold, further complicating the calculations. Also, see below for how the option pool fits into the waterfall.
On the one hand, if the Series A liquidation preference is greater than the net consideration, then whatever consideration is available will be allocated pro rata to the Series A and the common stock will not receive anything.
On the other hand, if the net consideration is significantly greater than the cumulative Series A liquidation preference, the Series A stockholders might be better off to convert into common stock to avoid any cap on return in the charter. Completing the waterfall thus requires running the numbers to examine the payment to be received by the Series A stockholders in the event they all converted to common versus the amount they would receive under the liquidation preference (and participation with the common stock, if they have that feature). Whichever option leads to the highest payout to the Series A stockholders is the path the Series A will take.
Further complicating matters are outstanding securities convertible or exercisable for shares of the company’s stock. The most common are stock options issued under an incentive stock plan. If the amount to be paid per share of common stock under the waterfall is greater than the strike price of a stock option, it makes sense to exercise the option (assuming the option is vested); this means that the options are in the money. The optionholder would receive the difference between the price per share of common stock and the strike price of her option. However, as options are exercised in this case, the number of shares of common stock is increasing and thus the price per share to be paid to the holders of common stock decreases. The waterfall must account for this fact. Options issued at different times may have different strike prices, based on changing valuations of the company over time; the waterfall must also handle the fact that certain groups of options may be in the money while others are not.
Warrants to purchase stock may also be outstanding, and are subject to the same type of analysis, although the legal rights built into warrants are usually more friendly to the individual investor than the option plan is to the optionholder. If the price to be paid per share for which the warrant is exercisable is greater than the strike price of the warrant to purchase such a share, it would make sense to exercise the warrant, with the resulting depression of the consideration available per share to that class or series of stock. Eventually there could be a tipping point, where the exercise of options or warrants that are in the money beyond a certain point reduces the price per share of the underlying stock that these securities are actually no longer in the money. Although these situations are not common and only arise for very specific purchase prices, the waterfall needs to address them or at least recognize them so further analysis can be undertaken.
Outstanding convertible promissory notes present even more of a challenge. Frequently, if convertible debt hasn’t previously been converted into preferred in a round before the exit, these notes have the option to convert at a discount to the most senior series of preferred stock in any liquidation event; sometimes the holder can simply demand repayment at an exit (before any of the waterfall flows to the cap table). Of course, the debt accrues interest too, which changes over time. So, compiling the waterfall means taking into account whether it is more advantageous to the noteholders’ to have the principal and accrued interest paid off , or to convert (at their discount if available) into preferred stock and enjoy whatever liquidation preference comes with conversion. Additionally, some notes could have complicated or unique features triggered on a liquidation event (such as various multiples of principal to be paid out); these are generally referred to as “downside protection” and need to be accounted for.
Additional levels of complexity can arise from having multiple series of preferred stock. Each series will generally have its own liquidation preference and other features. The waterfall needs to account for all of these various preferences and rights to determined how each stockholder of the company will end up getting paid based on the net consideration in an exit scenario.
Creating a waterfall is a delicate and often time-consuming process. It will also rely heavily on the company’s cap table, which is just one more reason why having a current and accurate cap table is a necessity.