What is the Waterfall Method?
The Waterfall Method in valuation is the process of determining the value of an investment into a private company at a given valuation of the private company. It takes into account the economic and legal rights and preferences of the various classes of debt and equity during the distribution of value in a given liquidity event.
For example, if a company takes a $1,000,000 investment with a liquidity preference for return on investment and then sells to another private company at any price up to $1,000,000, all of the sale will go to paying back that investor first. There are often several tiers of distribution, and the waterfall method is useful for understanding where in the order of distribution any given stake is, so that an analyst can determine the exit value of the stake.
In ASC 820 valuations, this method is useful for allocating the enterprise value of a portfolio company to the actual stake in the portfolio being valued.