The times when investors were able to simply calculate the return on investment based on their ownership percentage in the company have long gone. Term sheets have become ever more complicated that it is very easy for investors to calculate their returns incorrectly.

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A waterfall analysis is a complex economic return modeling tool that presents the sequence of distribution of proceeds to the various stakeholders of the company at time of exit, based on multiple factors. The main ones include:

Capital Structure: For most start-ups, common shares and common options are at the bottom of a long stack of debt, convertibles notes, preferred stock and preferred warrants.  Carefully analyzing the split between debt and equity and seniority among all equity and equity derivatives instruments of a company is a key factor in any exit waterfall model.

Rights Attached to Equity: As further explained below, not all preferred shares have the same rights. Liquidation Preferences types, dividends, anti dilution protection mechanism, conversion rights, options acceleration and other vesting terms for options, all greatly impact an early-stage investor’s overall returns.

Exit Strategy: the analysis for a merger and acquisition (“M&A”) exit scenario is materially different than for an initial public offering (“IPO”) one. In an IPO all preferred shares automatically convert into the publicly-traded common stock and therefore liquidation preferences become a non-factor. However, an exit via IPO comes with different complications, structures and lock-ups that effect the waterfall model.