Meaning
Contractual allocation schedules define the order and proportion in which cash from a liquidation or exit is distributed among different classes of security holders. In private equity and venture capital transactions, the asset distribution waterfall governs how proceeds from a sale or winding up are partitioned. This structure dictates that senior debt is cleared first, followed by preferred equity, and finally common equity.
Each tier must be paid in full before cash flows to the next. Subordinated debt holders wait behind senior lenders but stand ahead of all equity classes in the queue.
Payment Sequence
Senior creditors receive full payment before any junior equity holders get cash. The cash then flows to holders of preferred stock up to their agreed return thresholds, leaving the residual amount for common shareholders. This process prevents disputes during an exit by establishing clear numerical rules in the shareholder agreement.
Liquidation Preference
Preferred shareholders negotiate specific multipliers that dictate their minimum payout during an exit event. This mechanism can include participating or non-participating rights, which alter the share of remaining assets. When preferred shares are participating, the holder receives their preference amount and then shares in the common pool.
Investor Protection
Institutional venture capitalists utilize structured payout orders to mitigate the risk of capital loss. The arrangement ensures that even in a low-value exit, the initial capital is recovered before founders or employees receive payouts. This right is a control provision that influences the pricing of subsequent funding rounds.
