Liquidation Waterfall
The defined order in which exit or liquidation proceeds are distributed across a company's different classes of stockholders.
The waterfall determines exactly who gets paid, in what order, and how much when a company is sold or liquidated — typically starting with any secured debt, then preferred stockholders' liquidation preferences (often paid in reverse order of seniority, most recent round first), then remaining proceeds to common stockholders, subject to any participation rights along the way.
Modeling the waterfall accurately for a specific deal size is essential for understanding real outcomes for founders and employees, since the headline exit valuation can be very different from what common stockholders actually receive once every preference, participation right, and option strike price is accounted for.
A company with $8M raised across two preferred rounds (each 1x non-participating) is acquired for $25M. The waterfall pays $8M total in liquidation preferences first, leaving $17M distributed pro-rata across all remaining as-converted shares (preferred converting to common since it's worth more than the fixed preference at this exit size, plus common and options).
Build a real waterfall model — not just a back-of-envelope estimate — before any acquisition negotiation or even before signing a new round's term sheet, so founders and the board understand exactly how proceeds actually flow at different possible exit valuations.
Do preferred investors always take their liquidation preference over converting to common?
No — they take whichever is larger: the fixed liquidation preference, or what they'd receive by converting to common stock and taking their pro-rata share, which is typically larger only in strong exits well above the total preference stack.
Related terms
Run the numbers yourself: dilution, SAFE conversion, and fund-returner calculators.