Meaning
Contractual order of payment determines the sequence in which different classes of shareholders receive funds during a company sale or liquidation. Preference waterfall as a mechanism is defined in the articles of incorporation and sets the priority for the distribution of the exit proceeds. The hierarchy ensures that senior investors are paid their agreed amounts before any capital reaches the common stockholders.
Liquidation Sequence
Each layer of the structure must be fully satisfied before the next group of owners receives a cent. A preference waterfall usually begins with the return of the original investment amount to the preferred shareholders. If funds remain, they are then distributed according to the participation rights of each class.
This process ensures that senior capital is recovered before juniors share in any gain. The hierarchy is established at the time of the share issuance.
Investor Security
This arrangement protects late stage investors who pay a higher price for their shares. Through the preference waterfall, these parties ensure that they are the first to recover their capital in a downside scenario. The complexity of the waterfall increases with every new round of financing.
Economic Outcome
The final amount received by the founders depends entirely on the total value of the exit and the size of the preferences above them. In many cases, a low sale price results in the preference waterfall leaving nothing for the common equity holders.
