In simple terms a waterfall analysis is simply the technical terminology used to define the method of computing exact values each individual shareholder and secured debt holder is going to be paid upon any acquisition transaction of the business (e.g. an acquisition, an IPO, or a sale). Essentially it’s just a series of complex mathematical equations where you use the various financial terms associated with the business to compute the correct amount to pay each recipient in a given period of time. startups sounds complicated but it is a very robust and tested methodology which has been applied successfully over decades and is well accepted in most industries (and at the personal level too! ).

In order to understand what waterfall analysis is all about, you need to know what exactly are the different types of financing options available to any business owner? Well there are two main types of financing options available, i.e. equity and preferred stock. Equity financing is also known as commonly as an open market option; if you have secured a large sum of money then you can usually go in and buy up a considerable number of shares which majority owners will then share in your success (i.e. diluting their ownership).

This then allows you to sell those shares at a profit (known as a “preferred” or “underwater” issue) and then repay the money borrowed. Most businesses then take the equity route as it offers the greatest potential for long term and cheap growth. Preferred stock however only really becomes attractive to companies and organizations when they have a solid earnings history and/or a large cash flow coming in. Usually startups of companies only want to deal with larger cap companies as they have the ability to put more capital into the business and have the ability to pay out a higher dividend. The waterfall analysis is then conducted once the company is established as being fairly stable and growing and the dividends start to become significant. This then allows the investor to decide whether to cash in on their investment by issuing shares to the general public.

As well as equity financing there are also other methods of raising funds, such as through issuing new shares on the stock market. These typically include new issue or preferred stock options; these stock options can only be issued by a company if they meet certain requirements (listed below). startups cost the company money and they also need to provide a “call” or “put” option; this means that a shareholder can sell his or her new shares to someone else for immediate cash (known as a “call” option). However, if the shareholder wants to keep his or her shares and also wants the company to make money then he or she needs to allow the company to exercise its “put” option – this means that the shareholder can now sell his or her new shares to the company for cash.

The exercise of both options grants a right to sell shares at a specific price (the “strike price”). Once the company sells the majority (usually around) of its shares, the stockholder will now be able to sell his or her own shares at the strike price provided by the company. There is also a “put” option which is used by the stockholder; this means that the shareholder is allowed to sell his or her shares at the strike price plus the cost of his or her option grant plus the additional payment made by the company. Both these options provide the stockholder with the opportunity to receive cash from selling their shares.

Issuing stock with warrants is another method of equity financing which many investors use. In the past, when companies needed to raise money, it was common for them to issue warrants to their stockholders. A warrant is simply an agreement between a company and its stockholder where the latter agree to buy at a fixed price in exchange for paying a particular sum of money up front. The most common example of a convertible note is the warrant which can convert into shares of the issuing stock on a particular date (known as a “conversion date”).

When it comes to conversion, investors must make sure that they understand what is happening. Most often, the conversion of the warrant will only occur if the market value of the issuing stock rises more than the amount of the option exercise plus the cost of the warrants (commonly referred to as the “premium”). It is for this reason that many investors only ever purchase convertible notes and not warrants when they have significant doubts about the market value of the business in question. In most cases, a simple cap table which gives an indication of conversion rates for different values of the stock may be more useful to investors than the actual exercise prices. Moreover, because convertible notes are sold under an assumed set price, the actual costs of the note may vary significantly from the underlying value of the issuing stock.

An alternative method of equity financing is to use Carta to issue company stock. Carta’s founders argue that the simple cap table is only useful to investors who only wish to buy one or two million shares as an initial purchase. As a result of this limitation, many start-ups opt instead for a sophisticated Carta system which is designed to provide an exact prediction of share price for the entire run of a business. This allows investors to buy shares without worrying about potentially losing money over time. Additionally, a Carta system will automatically provide an exit strategy, should the business become unprofitable. This means that an investor will not be left holding a poor investment for years on end as their business becomes unprofitable and they are unable to sell their shares to obtain additional capital.