Tuesday, February 14, 2012

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

White Summers  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.

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