Exit Waterfall
An exit waterfall is the distribution model that determines how proceeds from a company sale or liquidation are paid across preferred and common shareholders. Allocators evaluate waterfalls because preference stacks, participation, and seniority can cause “headline exits” to produce far less distributable cash than expected.
Many venture discussions focus on valuation, but realized outcomes depend on waterfalls. A company can sell for a meaningful headline value and still generate weak returns to a fund if preferences are stacked, participation is aggressive, or dilution has eroded ownership.
From an allocator perspective, waterfall literacy is essential because it clarifies:
- who gets paid at each exit value,
- how structural terms affect realized multiples, and
- whether “paper marks” are actually distributable.
How allocators define waterfall risk drivers
They assess:
- Preference multiples and seniority: what is paid first and to whom
- Participation: whether preferred shares double-dip
- Conversion decisions: when preferred converts to common for upside
- Option pool dilution: impact on common payouts
- Multiple rounds: stacking effects across financing history
- Threshold outcomes: at what exit value common begins to receive proceeds
Allocator framing:
“At realistic exit values, who actually gets paid—and what does that imply for fund-level DPI?”
How waterfalls are used in diligence
Allocators want:
- scenario analysis ($50M/$100M/$300M/$1B outcomes)
- distribution estimates by shareholder class
- sensitivity to new senior rounds and structure changes
What slows allocator decision-making
- GPs reporting headline valuation without waterfall context
- reluctance to disclose preference stacks and participation terms
- marks that assume clean conversions despite stacked seniority
- lack of evidence from realized exits
Common misconceptions
- “Exit value equals returns” → returns depend on waterfall structure and ownership.
- “Preferences only matter in failure” → mid exits are where waterfalls matter most.
- “Founders always win in big exits” → only if preferences and dilution allow it.
Key allocator questions
- What does the waterfall look like across realistic exit values?
- How often do preference stacks impair returns in your portfolio?
- How do you manage participation and seniority in down markets?
- What is your policy on transparency for structural terms?
- What are examples of realized exits and their waterfall outcomes?
Key Takeaways
- Exit waterfalls determine distributable outcomes, not headline valuations
- Preference stacks and participation can materially impair returns
- Preference stacks and participation can materially impair returns