At its core, a waterfall in venture capital refers to the mechanism by which proceeds from a liquidity event (like an acquisition or IPO) are distributed among various stakeholders in a startup. These stakeholders primarily include:
Founders: The individuals who created the company.
Investors: The venture capital firms and angel investors who provided funding.
Employees with Equity: Key employees who have stock options or shares.
Other Creditors: Sometimes banks or other lenders with claims on the company.
The waterfall structure dictates the order in which each group receives their share of the pie and the specific terms under which they receive it. The "waterfall" metaphor is used because the proceeds typically flow down to different groups, like water cascading down a series of steps.

Key Differences: American vs. European Waterfall Structures
While both American and European VC waterfalls aim to fairly distribute returns, they often differ significantly in their complexity, priority, and prevalence of specific terms.
Simplicity vs. Complexity
American: Generally, American waterfalls are known for their relative simplicity and transparency. They often follow a more linear and easier-to-understand process, typically prioritizing preferred stock investors first.
European: European waterfalls are often more complex, incorporating various features that can significantly impact the ultimate distribution of proceeds. They tend to be more bespoke, tailored to the specific financing round and investor relationships.
American: A common structure is the "1x non-participating preference." This means that investors who hold preferred stock receive back their initial investment (1x) before the common stockholders (usually founders) get anything. Once the investors receive their money back, they no longer share in additional proceeds and the remaining amount is distributed among the common stockholders.
European: European waterfalls can be very varied, with the prevalence of participating preferred stock (sometimes up to 2x or 3x). In a participating preference scenario, preferred stockholders not only receive their initial investment back first (1x, 2x etc.) but also continue to participate in further proceeds alongside common stockholders based on their proportional ownership once the initial preferred amount has been paid. This often results in European investors receiving a larger portion of proceeds, especially in high-value exits.
Multiple Layers of Preferences (Seniority)
American: While it's possible to have different series of preferred stock with varying preferences, they are often handled relatively straightforwardly. Often only a simple set of A, B, or C series of preferred shares are created.
European: European structures often include multiple layers of preferences, where different investment rounds might have distinct seniority and participate differently in the liquidation waterfall. This is particularly true for companies that have gone through many rounds of financing. This complexity is designed to reward early investors.
American: These are less common in American structures, meaning the waterfall is typically more linear.
European: Catch-up provisions are more common, which often means that investors are entitled to receive further payments once certain milestones are achieved before proceeding to common stock. For example, once initial preferred money is given, participating preferred shareholders might receive additional money until they have reached a certain multiple (e.g. 2X or 3X) of their original investment and then the regular waterfall continues.
American: The option pool, which represents shares set aside for employees, is often treated as part of the common stock and is calculated before any proceeds are distributed.
European: The handling of the option pool can vary, with some structures considering it before or after the preferred shareholder payout depending on the investor preferences.
Detailed Examples
Let's use a simplified example to illustrate how the differences could play out.
Scenario: A startup is acquired for $100 million. The company had raised two rounds of investment.
Seed Round: $5 million raised from angel investors in Series Seed, with common shares.
Series A: $15 million raised from VC firm in Series A preferred stock.
Founders: The remaining shares are held by the founders, common shares.
Option Pool: Option Pool of 10%
Example 1: Simple American 1x Non-Participating Preference
Option Pool: The option pool is determined pre-money as the employees must be allocated a set amount of shares before the sale takes place. The option pool would take up $10 million.
Series A Investors: Series A investors receive their initial $15 million.
Remaining Proceeds: $75 million. This is distributed proportionally based on equity ownership between the seed investors and founders in common shares.
Outcome:
Series A investors: $15 million.
Option Pool: $10 million.
Remainder: Split proportionately based on ownership
Example 2: European Participating Preference (2x) with "Catch-up" Provision
Option Pool: The option pool is determined pre-money as the employees must be allocated a set amount of shares before the sale takes place. The option pool would take up $10 million.
Series A Investors: Series A investors receive their initial $15 million.
Series A Catch-Up: Series A investors receive an additional $15 million (making a total of $30 million or a 2x return on their investment).
Remaining Proceeds: $60 million. This is distributed proportionally based on equity ownership between the Series A, seed investors and founders in common shares.
Outcome:
Series A investors: $30 million
Option Pool: $10 million
Remainder: Split proportionately based on ownership
Example 3: Complex European Waterfall with Multiple Layers
This example gets even more complex, highlighting some nuances. Let's assume the company also raised a Series B in this example.
Seed Round: $5 million (common shares)
Series A: $15 million (1x Participating Preferred)
Series B: $20 million (2x Participating Preferred)
Founders: Remaining shares are held by the founders
Option Pool: Option Pool of 10%
Option Pool: The option pool is determined pre-money as the employees must be allocated a set amount of shares before the sale takes place. The option pool would take up $10 million.
Series B Investors: Series B investors receive their initial $20 million.
Series B Catch-Up: Series B investors receive an additional $20 million, totaling $40 million (2x)
Series A Investors: Series A investors receive their initial $15 million.
Series A Catch-Up: Series A investors receive an additional $15 million, totaling $30 million (2x).
Remaining Proceeds: $20 million. This is distributed proportionally based on equity ownership between the Series A, Series B, seed investors and founders in common shares.
Outcome:
Series B investors: $40 million
Series A investors: $30 million
Option Pool: $10 million
Remainder: Split proportionately based on ownership
Key Takeaways
Investor Power: European waterfalls tend to favor investors more significantly than the American counterparts, especially due to the use of participating preferred stock, catch-ups, and complex seniorities.
Complexity & Negotiation: European deals are more likely to require thorough legal advice and negotiation. Waterfall calculations can be very challenging and must be carefully reviewed.
Founder Impact: The more complex the waterfall, the less likely the founders are to get significant returns in lower exit scenarios. American structures tend to be less punitive, meaning there is a higher chance for the founders to benefit from early exits.
Understanding the nuances of American and European waterfall structures is crucial for both investors and founders. These structures influence risk-reward profiles, the speed of return, and ultimately, the overall outcomes for all stakeholders in the company. By carefully negotiating these terms and consulting with experienced legal and financial advisors, founders can ensure they retain a reasonable amount of control and benefit from the success of their business while investors can have a clear and fair path to return on their investment. This article provides a detailed look but is not a substitute for professional legal and financial advice. Every deal and situation can vary, and it is imperative to consult with experts who have experience in these matters.
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