So, you want to chase waterfalls?

While it might be tempting to take the advice of TLC not to chase waterfalls and instead “stick to the rivers and the lakes that you’re used to”, growing a business (especially in a meaningful way) can often only be achieved through not sticking to what you are used to, and rather grasping what some view is the nettle of venture capital investment.

Unfortunately, when dealing with venture capital, you are unlikely to be able to have it “your way or nothing at all”. Quite often, the opposite is true. A case in point is the so-called “waterfall” or “liquidation preference”.

Simply put, the liquidation preference determines how the surplus assets of the company will be distributed to each class of shareholders (once secured and unsecured creditors have been paid). This will occur either upon liquidation of the company or upon the divestment of the company (i.e., a share or asset sale or initial public offering).

Without a waterfall embedded in the company’s articles of association, the default position is that surplus proceeds on a winding-up or divestment will be distributed to all shareholders proportionately to their shareholding. A venture capital investor will want to place themselves at the top of the waterfall in a distribution of surplus assets, so they recover not only their capital investment ahead of/preferentially to other shareholders, but also ideally get to participate in the remaining surplus assets.

A liquidation preference is just one of the special rights that a VCT investor may insist on; others being fixed (cumulative) dividends, the right to convert to ordinary shares and the right of redemption for cash.

Types of Waterfall Clauses

Not all waterfall clauses will look the same, they will be negotiated between the founders and the investors – but there are common types which are outlined below.


In a non-participating liquidation preference, before any other shareholders receive any proceeds, the investor shareholder will be paid the subscription price for their shares (or a multiple of them) together with any declared but unpaid dividends. Any remaining proceeds are then proportionately shared by the other shareholders. This protects the investor from the downside on its investment; however, its upside on the distribution of surplus assets is limited. This type of liquidation preference is most favourable to the founders of the company.

Full Participating

In this type of waterfall, the investor has its investment (or a multiple of it) returned first on the same basis as a non-participating liquidation preference. However, the investor is additionally entitled to participate proportionally alongside the other shareholders in the balance of any surplus. This means the investor has a double-dip – not only is its downside risk protected (like in a non-participating liquidation preference) but it is entitled to participate in any upside. This type of liquidation preference is most favourable to investors in the company.

Capped Participating

This is identical to the full participating, save that the investor may only participate pro rata with the other shareholders once they have recovered their initial investment (or a multiple of it) up to a maximum amount (usually expressed as a multiple of their investment). After the cap is reached, only the other shareholders participate in any surplus assets.

If the surplus assets are high, where the investor has a non-participating or a capped participating preference, they could receive less than if they had been paid out in proportion to their shareholding. For this reason, the investor often has the right to convert their shares to ordinary shares, forfeit the liquidation preference, and participate proportionally in any surplus with ordinary shareholders.

Dead Zones

It is also worth noting that depending on the amount of the surplus proceeds to be distributed, the interests of the investor shareholders and ordinary shareholders can become misaligned ‐ this is due to the creation of dead zones. In dead zones, the ordinary shareholders may not be incentivized to seek an increased exit price as their exit return remains flat compared to the investor shareholders whose return would increase if the exit price increased. In some liquidation preferences, the reverse is true.


Where shareholders are looking to raise money using the tax-efficient Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) special care must be taken. For SEIS/EIS investment relief to apply, the rule is that on a winding-up event there can be no liquidation preference for some shareholders over others. On winding up, any surplus assets must be returned to all shareholders in the same proportion based on the subscription price for the shares and the number of shares held. The rationale for this is that to receive tax relief, the investment must be truly at risk and so must not be protected on winding up by mechanisms such as liquidation preferences. However, the relief is only impacted by preferences on a winding up; it is not impacted by preferences on a sale of the company or its assets, meaning that liquidation preferences can be incorporated to allow investors to take upside on a sale of the business. Swivel and ratchet mechanisms can also be used to allow the investor to recover its initial investment while still complying with HMRC rules.

Our View at Garfield Smith – Technology & Data Lawyers

Not all waterfalls are created equal; what the liquidation preference embedded in the company&rssquo;s articles of association will look like will ultimately come down to the balance of power between the existing shareholders and the new investors. Given the importance of downside and upside risk allocation, early engagement on the terms of the liquidation preference is advisable at the term sheet stage.

At Garfield Smith – Technology & Data Lawyers we have extensive experience in advising companies preparing for, negotiating and finalising investments. If you have any considering investments for your company or have any questions or comments on any of the issues covered by this briefing please do not hesitate to contact us.

8 August 2022


  • Garfield Smith
    Garfield Smith Senior Solicitor
    Managing Director
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  • Amanda Sermon
    Amanda Sermon Senior Solicitor
    Head of Corporate Finance
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