Importance of Waterfall Analysis for VC Investment

In this article, we discuss the importance of waterfall analysis for VC investment.

A private equity investment structure’s purpose is to align the interests of all parties involved in a single deal or a private equity fund. Private equity waterfalls can take many different shapes, depending on each party’s aims and whether or not the other investor has the right incentives in the transaction. While successful alignment necessitates both legal and financial procedures, we will concentrate on the distribution waterfall, which is the key financial incentive for parties to align their interests. In this article, we discuss the importance of waterfall analysis for VC investment.

Waterfall analysis and VC investment

A waterfall chart, also known as a cascade chart or bridge chart, is a graph that demonstrates how a starting value is influenced by intermediate values, both positive and negative, to produce a final value. Waterfall charts are commonly used to analyze data in a sequential manner, which can be useful for getting VC investments. Venture capital (VC) is a type of private equity investment offered by venture capital firms or funds to startups, early-stage, and developing businesses that have shown great growth potential. The growth potential of a business can be illustrated by using a waterfall analysis.

What is waterfall analysis?

When studying a progressive transition in the quantitative value of a variable that is subjected to growth or decreases incrementally, waterfall charts are very beneficial. Values in the analysis might be categorized or depending on time. Floating columns represent intermediate values based on the value of the previous column, while whole columns represent final values. Complex analyses with several columns and data that cross the axis can be represented using waterfall analysis.

Understanding VC investment

The most prevalent sources of venture capital are well-heeled investors, investment banks, and other financial institutions. Venture capital firms are investment firms that invest in and mentor startups and other young, often tech-focused businesses. Like private equity (PE) firms, VC firms invest in potential private enterprises with capital raised from limited partners.

How does the distribution waterfall work for VC investment?

The technique by which capital is allocated to a fund’s numerous investors as underlying investments are sold for gains is referred to as a distribution waterfall. The total capital gains earned are divided in a cascading system made up of successive layers, which is why the term “waterfall” is used.

Why should companies need to structure waterfall distribution?

Waterfalls in private equity are a way of allocating capital gains or investment returns among all investors. Equity waterfalls benefit limited partners (LPs), who are investors, and the general partner (GP), or sponsor, who might be property managers, real estate firms, or corporations. The phrase “waterfall” refers to how an investment’s revenues trickle down to everyone associated with the business.

This structure permits managers to be paid before investors receive all of their contributed capital and preferred return, though the investor retains their rights. After investments have been liquidated, a private equity fund distributions are paid out in a waterfall structure.

4 tiers of waterfall analysis

The name of the allocation comes from the cascading nature of its four constituent tiers, which are depicted below. Another layer is the hurdle rate, which is the minimal rate of return on an investment that an investor requires. If the management or general partner receives an excessive incentive fee, the PPM contains a “clawback” clause that requires the excess fees to be returned.

  • Return of capital – Investors get their initial capital contributions back, plus certain expenses and fees. They receive 100% of distributions until they have recovered all of their initial capital contributions, which is known as return of capital (ROC).
  • Preferred return – The LPs receive 100% of the payout until the preferred internal rate of return is met based on all distributions to them and all contributions called. Investors receive 100% of future dividends until they receive the desired return on their investment. The preferred rate of return for this tier is usually about 7% to 9%.
  • Catch-up – Until the fund’s sponsor receives a specified percentage of profits, 100% of the dividends go to the fund’s sponsor. The general partner benefits greatly from the catch-up bucket. They are awarded all or a large share of the profit until they reach a certain profit percentage.
  • Carried interest – It is the distribution of the leftover funds among the limited and general partners. Carried interest is a percentage of the dividends received by the sponsor. The fourth tier’s stated percentage must match the third tier’s stated percentage.

Waterfall analysis for VC investment

The technique by which capital is allocated to a fund’s numerous investors as underlying investments are sold for gains is referred to as a distribution waterfall. The total capital gains earned are divided in a cascading system made up of successive layers, which is why the term “waterfall” is used. An investment waterfall is a way of dividing earnings among transaction participants that allow for an uneven distribution of profits. The waterfall structure can be thought of as a sequence of pools that fill up with cash flow and then spill over into new pools once they are full.

How does waterfall analysis help with VC investment?

In a private equity investment agreement, a distribution waterfall lays out the rules and methods for profit distribution. Its primary goal is to match general partner incentives and design a pay structure for limited partners. A series of buckets can represent the distribution structure stacked one on top of the other. Each bucket designates a profit distribution. When the first bucket is full, the profits are transferred to the second, and so on. Capital moves from limited partners (favored by the initial buckets) to the general partner in this fashion (favored by buckets further away from the source). This type of allocation structure protects investors’ interests while also incentivizing them.

How to do waterfall analysis for VC investment?

The proceeds of a project are divided evenly among the partners in a standard equity waterfall. Operating partners receive a larger percentage of revenues when a project exceeds expectations. A “promote” is an additional slice of the pie. Waterfalls are visual representations of the sequential breakdown of a starting value (such as revenue) into a final result (such as profit) by illustrating intermediate values and leakage points. Companies can use this tool to keep track of data at each step.

  • Understand and analyze investment contract – An investment contract is a legal agreement between two parties in which one invests money to get a profit. Because the investment agreement deals with the investors’ subscription for shares in exchange for their investment funds, it should bind all participants, including any independent funds that are investing.
  • Keep an eye on free cash flow – Free cash flow might reveal information about a company’s health. If you have a lot of free cash flow, it means you have enough money to cover your operating expenses plus some. The money left over might be used to pay out dividends to investors, reinvest in the company, or purchase back stock.
  • Build cash flow tiers – A development or investment project’s cash flow can be split in an infinite number of ways, which is why real estate waterfall models can be so perplexing.

How does return on investment work in waterfall analysis for VC investment?

A waterfall analysis is a sophisticated economic return modeling technique that depicts the distribution of proceeds to the company’s many stakeholders at the moment of exit, based on a variety of factors. Common shares and common options are at the bottom of a long stack of debt, convertible notes, preferred stock, and preferred warrants for most start-ups. A significant aspect of any exit waterfall model is carefully assessing the mix between debt and equity, as well as seniority across all equity and equity derivatives instruments of a corporation.

Types of liquidation preferences, dividends, anti-dilution mechanisms, conversion rights, options acceleration, and other vesting terms for options all have a significant impact on the overall returns of an early-stage investor. The analysis for an exit scenario involving a merger and acquisition (“M&A”) differs significantly from that of an initial public offering (“IPO”). Due to the immediate conversion of all preferred shares into publicly-traded common stock in an IPO, liquidation preferences become irrelevant. However, an IPO exit comes with its own set of problems, structures, and lock-ups, all of which have an impact on the waterfall model.

Waterfall analysis for VC investment

Typically, while considering an investment, investors will perform a waterfall analysis. They must calculate their return if the company is sold for $50,000,000, $100,000,000, $200,000,000, and so on. When they compare this to what they believe the firm will sell for, with room for error, they get a multiple of their investment in the company that they might potentially profit from.

To demonstrate this analysis, let’s look at an example:

Assume investors buy $5,000,000 of participating preferred shares with a 3x return on investment. For the sake of simplicity, assume that the stock purchased by investors is the company’s only preferred stock. Let’s also assume that, after the purchase, investors will hold 5% of the company in a fully diluted form.

In our scenario, investors receive $7,250,000 [$5,000,000 return on investment + 5% of the remaining sale profits of $45,000,000], which isn’t terrible considering the investors invested based on a $100,000,000 valuation. If the same firm sells for $100,000,000, the valuation at which the investors invested, the investors will receive $9,750,000 [$5,000,000 return on investment + 5% of the remaining $95,000,000 sale proceeds].

How are American and European waterfalls different from each other?

A European waterfall distributes 100% of all investment cash flow pro-rata until the preferred return is achieved and investors receive 100% of their invested capital. This is a typical and appropriate structure for equity funds, which allows an investor’s capital to be dispersed across 20 different businesses. The European structure’s major flaw is the manager’s compensation structure, which may demotivate him or her to maximize long-term investment results. The American waterfall distribution, on the other hand, is used on a deal-by-deal basis. It favors the fund’s general partners over its limited partners and prioritizes profit distribution to the GP. It may, however, include a “clawback” clause in the agreement to entice investors to the equity fund.

Which waterfall analysis you should use for VC investment?

Waterfalls are an important aspect of real estate investment terminology, specifying how money is dispersed to investors and transaction sponsors in a logical order. They ensure that the deal is set up to reach outsized success when structured right — with aligned incentives.

How can Eqvista help with waterfall analysis for VC investment?

The term “waterfall” is used to describe how money from an investment is distributed to the many parties involved. The top-down nature of the cash flow distribution reveals the parties’ relative priorities at various levels. Waterfall analysis is an extremely complicated process that must be performed by an expert, without prior knowledge one can not get the accuracy. We at Eqvista have a team of experts who can help you with this. Just fill-up sign up form the and get started with us.

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