Speaking VC Speak: Waterfall Analysis

In evaluating an investment, investors will usually run what is known as a waterfall analysis. In layman's terms, they have to analyze their take if this company is sold for... $50,000,000, $100,000,000, $200,000,000, etc. When they compare this against what they think the company is likely to sell for, with room for error, they have an idea what multiple of their investment in the company they potentially stand to gain from such investment.

Let's use an example to illustrate this analysis. Suppose investors are purchasing $5,000,000 of participating preferred stock capped at 3x of their investment. For simplicity, let’s assume that the stock purchased by investors is the only preferred stock outstanding in this company. Let’s assume further that after the purchase, investors will own 5% of the company, on a fully diluted basis.

In our example, in a $50,000,000 sale, investors get $7,250,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $45,000,000], which isn't a bad return given that in our example the investors invested based on a $100,000,000 valuation.

If the same company sells for $100,000,000, on the other hand, the valuation at which the investors invested, investors get $9,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $95,000,000]. In case you are wondering why the investors get back more than they invested even if the valuation of the company doesn't change, the answer lies in the participating liquidation preference.

Let's now consider a $200,000,000 exit. At this price, the investors receive $14,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $9,750,000], an almost 3x return on their investment.

What about if the company in our example sells for $350,000,000, a much better outcome for the investors? In that case, the investors’ return is $17,500,000 [5% of $350,000,000 because they would be above their cap for participating with the common stock and would opt for a return on a converted to common stock basis].

A basic understanding of waterfall analysis can be helpful for an entrepreneur in discussions with prospective investors.

Happy company-making to all!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.