Who Gets Paid First in an Exit? The Startup Waterfall Model Explained

Table of Contents

• Introduction
• What is the Waterfall Model?
• Share Classes and Distribution Priority
• 1. Liquidation Preferences
• 2. Seniority Levels
• 3. Participation Rights
• 4. Common Stock
• Impact on Founders
• The Hard Truth About Exits
• Protecting Your Interests
• Conclusion

Introduction

Ever wondered how money gets divided when a startup exits? What looks like a 'successful' exit on paper - say a $50M acquisition - can mean very different things for different stakeholders. As a founder, you need to understand the waterfall model - it's the framework that determines how money flows back to everyone involved, and why a big headline number doesn't always mean a big payday for everyone. Let's break it down.

What is the Waterfall Model?

Think of the waterfall model like a series of buckets stacked on top of each other. Money flows from the top, filling each bucket before spilling into the one below. In startup exits, these buckets represent different stakeholders - investors, founders, and employees - each with different rights and priorities in getting paid. If you're new to venture capital, you might want to check out our guide on How Venture Capital Firms Make Money to understand the bigger picture.

Share Classes and Distribution Priority

The waterfall model determines how different share classes get paid during an exit. Here's how it typically flows:

1. Liquidation Preferences

Investors with preferred shares are first in line. They usually get:

• Their original investment back (1x preference)
• Sometimes multiple times their investment (2x, 3x preferences)
• Any accumulated dividends (if applicable)

For example: If an investor put in $1M with a 2x preference, they get $2M before anyone else receives any funds.

2. Seniority Levels

Not all preferred shares are the same:

• Series C investors usually get paid first
• Then Series B
• Then Series A
• Then Seed investors
• Common shareholders (founders, employees, advisors)

Think of it like LIFO (Last In, First Out) - the most recent investors get their money out first, followed by earlier investors, similar to how a stack of plates works. The last plate you put on top is the first one you take off.

3. Participation Rights

Some preferred shares have "participation rights," meaning they receive:

• Their liquidation preference AND
• A share of the remaining proceeds alongside common stockholders

This is called "double-dipping" and can significantly reduce founders' returns.

4. Common Stock

Last in line are common stockholders (typically founders, employees, and early angels):

• Only get paid after all preferred claims are fulfilled
• Share any remaining proceeds proportionally
• May get little or nothing in modest exits

Impact on Founders

This priority structure means:

• A "successful" exit might not benefit everyone.
• Different exit values can trigger very different distribution scenarios.
• Early-stage terms become critically important in later-stage outcomes.

For example: A $50M exit might sound great, but after $30M in preferences and participating preferred shares, common stockholders might only see a small portion of the proceeds. This is one of many challenges founders face when taking VC money - learn more in our article about The Dark Side of Venture Capital.

The Hard Truth About Exits

Let's be honest: The waterfall model often creates a harsh reality check for founders and early angel investors. That exciting "$50M exit" you read about in TechCrunch? It might leave you with nothing but a good story to tell at happy hour.

Here's the uncomfortable truth:

• Founders can build a 'successful' company that sells for millions, yet walk away with surprisingly little.
• Early angel investors might barely get their initial investment back.
• Employees with common shares often end up last in line, watching their paper millions evaporate.

The waterfall model isn't just some abstract concept - it's a sophisticated mechanism that can drain value away from early believers and funnel it to later-stage investors with stronger preferences and protections.

Protecting Your Interests

As a founder, you need this knowledge not just to understand the game, but to protect yourself:

1. Negotiate liquidation preferences carefully - they are more significant than you realize.
2. Consider the impact of several rounds of funding on your exit proceeds. For a deeper understanding of funding rounds, read our Simple Guide for Entrepreneurs on Financing Rounds.
3. Be realistic about what 'success' actually means for your stake.
4. Model different exit scenarios before accepting investment terms.
5. Understand how each new funding round affects your potential payout.

Conclusion

The startup world loves to celebrate big exits, but remember: the headline number rarely tells the whole story. Understanding the waterfall model isn't just about being informed - it's about protecting your interests and ensuring your years of hard work actually pay off.

As a founder, this knowledge helps you negotiate better terms with investors and avoid the costly funding mistakes that can leave you empty-handed at exit. Don't just focus on raising money - understand how that money will flow when it's time to exit, and what it means for your stake in the company you've built. For founders looking to dive deeper into venture capital, our guide on Fund Management in Venture Capital provides additional insights into how VCs operate.

Sometimes, even with a solid understanding of the waterfall model, companies can end up in a challenging middle ground - neither failing nor achieving a successful exit. Learn more about this phenomenon in our article about "Living Dead" Investments in Venture Capital.