Meaning
A mathematical rule embedded within shareholder agreements to govern how distributable cash from asset sales or liquidation events travels through tiers of equity and debt holders. Liquidation preference schedules and distribution waterfalls rely on this framework to establish the exact sequence of payments before any common stock receives value. Jurisdictional constraints and insolvency statutes limit the reach of the rule by prioritizing secured creditors over equity claims regardless of contractual preferences.
Payout Priority
Contractual clauses deploy a capital allocation method to dictate how incoming funds satisfy outstanding obligations during an exit event. Senior lenders draw the first tranche of proceeds until principal and accrued interest reach a zero balance. Preferred shareholders subsequently receive their liquidation multiple before junior classes access residual capital.
Equity Waterfall
Mathematical precision governs the transition of capital from one tier to the next within the distribution schedule. Founders and ordinary shareholders wait until participating preferred instruments achieve their capped return thresholds. Numerical triggers dictate the exact moment conversion rights become economically rational for minority stakeholders.
Valuation Arbitrage
Discrepancies between enterprise value and liquidation preferences create severe tension during distressed exits. Common equity holders absorb all downside risk when asset realization values fail to clear senior debt obligations and preferred hurdles. Market downturns compress exit multiples and leave junior tiers with zero proceeds despite prior valuation marks on paper.
