Reference · Pricing & valuation
Waterfall
The order in which sale or liquidation proceeds are distributed across share classes and preferences.
Worked example
A worked example of proceeds flowing through a waterfall (illustrative figures):
- A company is acquired for $80 million. It has one round of preferred stock outstanding with a 1x non-participating liquidation preference, representing $30 million of original investment.
- The waterfall pays the preferred stack first: $30 million goes to preferred holders (or they convert to common if that yields more — in this case it doesn't, since their as-converted share would be worth less than $30M).
- The remaining $50 million ($80M − $30M) is split pro-rata among common shareholders — founders, employees, and anyone who holds common stock, including through a prior secondary purchase.
- A secondary buyer of common stock is, in effect, buying a claim on whatever is left after the waterfall clears the preference stack — which is exactly why understanding a company's full preference stack (not just its headline valuation) is step one of pricing any common-stock secondary purchase.
Where this trips people up
Waterfall terms are skimmed because they look like boilerplate, and then determine the actual split of proceeds. Whether the manager's carried interest is calculated deal-by-deal or across the whole fund, and whether a preferred return must be met first, can change investor outcomes substantially without changing the fund's headline performance figure at all.
Frequently asked
What is a preferred return?
A threshold return that investors receive before the manager participates in profits. Above it, the split typically shifts in the manager's favour, sometimes with a catch-up period that accelerates their share.
Why does deal-by-deal versus whole-fund carry matter?
Deal-by-deal lets a manager earn carried interest on winners before losers are realised, with clawback provisions meant to correct any overpayment later. Whole-fund defers carry until the fund as a whole clears its threshold, which is more protective of investors.
See the full glossary entry, or browseevery term.