White Lake News

Strategic Advisory

The Exit: Waterfalls explained & some innovative incentive structuring for growth Companies

by on , Comments Off


This article looks at how a typical waterfall for a sale of a VC backed company works.

So you are finally executing an exit or more importantly you are about to enter an exit process for your company and as CEO/CFO know that your common equity options are at the bottom of a long stack of debt, convertibles, preferred equity and additional warrant coverage. They are worth something for sure – but how much? Are the VCs motivated by a different target exit price than required by the management team to make a decent return? As CFO you need to understand these issues intimately to be able to work with all the shareholders and buyer in order to get a successful transaction approved.

The purpose of this article (where the accompanying excel is available should you email me) is to go through a simple example of how a waterfall works on an exit – in this case a trade sale. An IPO comes with different complications, structures and lock-ups. If you need to work with waterfalls then it is worth your while working through the figures and getting the excel attachment – if not – just read the descriptions and skip to section Alternative Ways to Incentivise…

The scenario – Company Dotcom Boom:

You have a company which is 6 years old.

The capital structure developed like this: You had initial angel funding (common equity) followed by a Series A (again in common equity), two preference rounds (Series B and C) – one of which occurred when you were under financial duress (running out of cash thus a down round and a liquidation preference was attached to this capital). In this Series C round the Series B prefs were forced to give up their liquidation preference in the negotiation so outside of some veto rights are essentially now common equity.

Also you have recently taken on some convertible debt with a rolled-up PIK interest to boost the company with some final growth in a new market before exit. This convertible debt also had 5% warrant coverage. You financed some asset purchases using senior debt which has a bullet payment trigger on a Change of Control. We will leave out any factoring instruments for now assumed to be covered by the working capital wind-up.

Employee options of some original senior management were underwater (ie strike prices way out of the money due to a recent down round) that Management have managed to negotiate a carve-out after debt with the VC of 1% of the sales price to ensure these vital senior managers are motivated through the sale process.

So at the last round (the Series C pref round) the company details were as such:


Figure 1 – Company Details (Series C)

The capital structure (debt & equity) from most senior to junior looks like this: – ignore the column on the far right for now – this is linked to the exit which I will now describe.


Figure 2 – Overall Capital Structure

After running a sale process with an Investment Bank a purchaser has signed an LOI to purchase the business for £140m Enterprise Value (EV – Debt + Equity less cash) with an agreed level of cash left plus working capital (cash and working capital equalisation on transfer we will ignore for now for simplicities sake).

The first thing we need to do is find what portion of the agreed purchase price is left for common equity to then come up with a share price. To do this – we need to know if the Convertible Debt will convert or not to come up with a fully diluted share number. This then affects the share price (equity value/number of shares)…which affects the decision on whether the debt will convert or not…which…(we have just entered a circular reference where we can be for a while……). In the excel file to calculate this we use a simple macro to bottom out on this circular reference and come up with a share price which automatically includes the conversion of the debt or not. The convertible debt has a convertible price of £3.50 (as agreed at a valuation in the original deal) – hence if any sale share price is above this figure the debt will take advantage of the conversion option and take the upside.

In our debt conversion example presented here – the end share price is £4.29 so yes the debt will convert. We then use this info to calculate the selling share price.


Figure 3 – Conversion Calculation

The Waterfall:
So with the debt converting – how does the waterfall work?

The first items to come off the total selling price will be:

  1. Banking fees (these may be a % on the EV or the Equity value)
  2. Senior debt
  3. Convertible debt – if it does not convert would come out now
  4. Next we have the negotiated Management carve out of 1% – given as a bonus as opposed toworked in shares (it can also be worked as a share claw back or issue).
  5. The preference shares are both participating or “double dipping” which means thepreference gets paid and then they participate “as if” converted to common equity again.
  6. At this point we have the capital available for distribution to ordinary shareholders – which will not include the participating preference shareholders, the converted debt, employeesand original common shareholders.


Figure 4 – Exit Valuation EV

So there you have it. Look back up to the Capital Structure before Exit chart to see the returns for each investor. Note how Series B’s potential returns were decimated by losing their liquidation preference in the last round negotiation and how the series C participation boosted theirs. Last capital in – especially in a struggling company controls the cap table.

The thing for management to think about in the sales negotiation is – “Due to the preferences, are the VCs incentivised to take a lower sales price than other shareholders or management and who controls the vote on the approval deal at Board or shareholder level?”

Fun and games indeed.

Alternative ways to incentivise management in an exit:

Over the years I have seen funds that are a lot smarter than others on the way they structure the cap table to incentivise management. One of my favourites I first saw executed by the Aloe Fund – whom I consider expert in incentivising management.

Their basic philosophy is thus: We are structuring our deals for a certain minimum return and once we have achieved this return we are prepared to share disproportionately with management from that valuation onwards to incentivise them to push for as high an exit as possible. Management are protected on the downside however on the upside will be prepared to work harder to achieve a certain minimum figure.

An example may be:

Management have 20% of the business. After a preferred return to the VC, they share 20% of common equity. However once the VC has made say 3X (or could be stated as an IRR) management share may rise to 40%. So say the VC has invested £40m at 1X Liq pref and the target return is 3X.

From the exit: The first £40m goes to the VC thereafter management share 20%. However once the VC has made £120m – thereafter management take 40% of excess returns.

Some thoughts on this approach:

While devising management incentivisation formulas based on upside, I think it is very important to remember that:

a. The upside is not so excessively large that it tempts the management to take on projects which are far too risky which they would not take in normal course.

b. Hence a business plan prepared by the management should be a first step which should clearly state how much additional funding they expect. Based on this – an exit valuation should be worked out and then accordingly management pay-out structured.

c. Additional % of the upside after a certain return is made by the shareholders can be a good motivator, however, if the management feels that they may just fall just short of the return made by investors then they will not get anything. This can have a demotivating effect at a certain point.

d. Hence instead of going for a 100% pay-out after 4x or 3x returns are made by investor, it is better to adopt a scale i.e.

  1. Management can be issued ordinary shares in the company and the investors preferred share with say 8% dividend.
  2. Management has to at least return the money to investors plus 8% return before they start sharing the returns.
  3. After this there can be a catch-up payment of say 20% – 40% to the management with usually a cap
  4. 100% share of upside for management at any point is normally unheard of
  5. In this structure, you can also keep the management motivated if things are not going as well as expected i.e. they see some returns to them. You do not want them to leave whenthings are turning bad as they do not see they can make 3x or 4x returns to the investors.

The way to structure this can be to have two classes of shares prefs and common with the return maths written into the Articles or Shareholder Agreements with example waterfalls also. This is less complicated than it seems. I have seen other ways of doing this by issuing special share classes to management on certain return criteria to investors.

Conclusion: Waterfalls and returns sharing can be as simple or complicated as you like. Some of the most complicated modelling I’ve ever seen has been on convoluted cap tables on an exit. The trick is to keep as simple and clear as possible whilst making sure your management team are incentivised through a sought after range of returns. However if you have multiple bridging rounds or downrounds – it will inevitably get complicated.

Author: John Rowland, Managing Partner, White Lake Group




The Exit: Waterfalls explained & some innovative incentive structuring for growth Companies