Venture-backed companies issue preferred stock with a liquidation preference: the right to get a defined amount back — typically the money invested — before common stockholders receive anything. Stack several rounds of preferences on top of each other and you have the waterfall: the strict order in which sale proceeds flow. Employees hold common. Common drinks last.
A worked example
A hypothetical company has raised $80 million across three rounds, each with a standard 1× non-participating preference, and preferred holders own 60% as-converted. The company sells for $100 million. Preferred holders choose the better of their preference or conversion: converting yields 60% of $100M = $60M, less than… no — more than their $80M preference only if the sale is large. Here, $80M preference beats $60M conversion, so preferred takes its $80M off the top, and the common — 40% of the cap table — splits the remaining $20 million. “The company sold for $100 million” and “the common received a fifth of it” are the same sentence. At a $300M sale, preferred converts instead (60% of $300M = $180M ≥ $80M), and everyone shares pro-rata — which is why exit size, not just exit existence, is what common holders should care about.
The features that change the math
Multiples: a 2× preference doubles the off-the-top claim. Participation: participating preferred takes its preference and shares in the remainder — “double dip” — sometimes softened by a cap. Seniority: later rounds often stand ahead of earlier ones (stacked) rather than alongside (pari passu). Each feature is a quiet transfer of exit value from common to preferred, negotiated when the round was raised, invisible until the sale.
Reading your own position
Ask (or find in the documents): total preference outstanding; multiples and participation; seniority order. Then run the two or three exit sizes that matter to you. The arithmetic takes ten minutes and replaces years of false precision from multiplying shares by headline valuations — a habit worth breaking.
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