Exit Waterfalls with Unconverted Convertibles

Exit Waterfalls covers how exit proceeds get allocated to equity shareholders. But what about investors who don't own shares yet? That's the case with unconverted convertibles: convertible notes, premoney SAFEs, postmoney SAFEs, and similar instruments still outstanding when a company exits before they've had a chance to convert.

For converting convertible notes and SAFEs in an equity round, see SAFEs and Convertible Notes.

In a normal exit waterfall, the core calculation is the keep-or-convert test: for each preferred shareholder, is it better to keep the preferred and take its liquidation preference, or to convert to common and take the common distribution? Unconverted convertibles need a version of that same test, with one extra step in front of it.

How to model unconverted convertibles

Unconverted convertibles need one alteration to the normal waterfall structure. A convertible holder doesn't own shares yet, so before you can test what they'd get by converting, you have to work out how many shares they would convert into. That share count isn't known going into the distribution; it's something you have to calculate.

The good news is that the legal documents tell you exactly how. Convertible notes and SAFEs both define what happens in a liquidity event that lands before a conversion event, and the rest of this doc walks through what those terms say.

Premoney SAFE

The premoney SAFE spells out what happens if a liquidity event arrives before the SAFE has converted. From its terms:

Liquidity Event. If there is a Liquidity Event before the expiration or termination of this instrument, the Investor will, at its option, either (i) receive a cash payment equal to the Purchase Amount (subject to the following paragraph) or (ii) automatically receive from the Company a number of shares of Common Stock equal to the Purchase Amount divided by the Liquidity Price, if the Investor fails to select the cash option.

In connection with Section (b)(i), the Purchase Amount will be due and payable by the Company to the Investor immediately prior to, or concurrent with, the consummation of the Liquidity Event. If there are not enough funds to pay the Investor and holders of other Safes (collectively, the "Cash-Out Investors") in full, then all of the Company’s available funds will be distributed with equal priority and pro rata among the Cash-Out Investors in proportion to their Purchase Amounts, and the Cash-Out Investors will automatically receive the number of shares of Common Stock equal to the remaining unpaid Purchase Amount divided by the Liquidity Price.

If the premoney SAFE has a discount rate:

"Liquidity Price" means the price per share equal to: the fair market value of the Common Stock at the time of the Liquidity Event, as determined by reference to the purchase price payable in connection with such Liquidity Event, multiplied by the Discount Rate.

If the premoney SAFE has a valuation cap:

"Liquidity Price" means the price per share equal to the Valuation Cap divided by the Liquidity Capitalization.

"Liquidity Capitalization" means the number, as of immediately prior to the Liquidity Event, of shares of Capital Stock (on an as-converted basis) outstanding, assuming exercise or conversion of all outstanding vested and unvested options, warrants and other convertible securities, but excluding:

(i) shares of Common Stock reserved and available for future grant under any equity incentive or similar plan;
(ii) this instrument;
(iii) other Safes; and
(iv) convertible promissory notes.

The method for calculating the share count in a liquidity event mirrors the math for calculating share counts for convertible holders in an equity raise.

So the waterfall calculation runs in order: first the Liquidity Capitalization, which gives you the Liquidity Price, which in turn tells you how many shares of common stock the note and SAFE holders would get if they convert. That "if" is the whole point. Whether they convert changes which share counts the waterfall uses.

Once you have the share price and the share count, the waterfall runs as normal. The same core test applies: does the SAFE holder take their cash-out amount (the liquidation preference, which here is the amount they put into the convertible), or convert into common shares?

The same structure applies for the Carta Premoney SAFE and other similar convertible instruments. However, an important sidenote regarding Carta's Premoney SAFE: in a conversion event Carta's default premoney SAFE is comparable to a YC premoney SAFE, but in a liquidity event Carta's premoney SAFE is comparable to a YC postmoney SAFE. Meaning, the terms that define company capitalization (for conversion events) and liquidity capitalization (for liquidity events) are comparably different between these structures.

Postmoney SAFE

Postmoney SAFEs also have similar terms (from Y Combinator):

Liquidity Event. If there is a Liquidity Event before the termination of this Safe, the Investor will automatically be entitled (subject to the liquidation priority set forth in Section 1(d) below) to receive a portion of Proceeds, due and payable to the Investor immediately prior to, or concurrent with, the consummation of such Liquidity Event, equal to the greater of (i) the Purchase Amount (the "Cash-Out Amount") or (ii) the amount payable on the number of shares of Common Stock equal to the Purchase Amount divided by the Liquidity Price (the "Conversion Amount"). If any of the Company’s securityholders are given a choice as to the form and amount of Proceeds to be received in a Liquidity Event, the Investor will be given the same choice, provided that the Investor may not choose to receive a form of consideration that the Investor would be ineligible to receive as a result of the Investor’s failure to satisfy any requirement or limitation generally applicable to the Company’s securityholders, or under any applicable laws.

If there is a discount rate:

"Liquidity Price" means the price per share equal to the fair market value of the Common Stock at the time of the Liquidity Event, as determined by reference to the purchase price payable in connection with such Liquidity Event, multiplied by the Discount Rate.

If there is a valuation cap:

"Liquidity Price" means the price per share equal to the Post-Money Valuation Cap divided by the Liquidity Capitalization.

"Liquidity Capitalization" is calculated as of immediately prior to the Liquidity Event, and (without double- counting, in each case calculated on an as-converted to Common Stock basis):

Includes all shares of Capital Stock issued and outstanding;
Includes all (i) issued and outstanding Options and (ii) to the extent receiving Proceeds, Promised Options;
Includes all Converting Securities, other than any Safes and other convertible securities (including without limitation shares of Preferred Stock) where the holders of such securities are receiving Cash-Out Amounts or similar liquidation preference payments in lieu of Conversion Amounts or similar "as-converted" payments; and
Excludes the Unissued Option Pool.

The postmoney SAFE calculation is close to the premoney one, with a single difference: its liquidity capitalization includes the shares going to every unconverted convertible holder who chooses to convert. Holders who don't convert aren't issued shares, so they drop out of the liquidity capitalization.

Convertible Notes

Convertible notes work much like premoney SAFEs here, with two differences that matter.

1. Notes vary far more in how they handle a liquidity event that beats the conversion event. There's no single standard, so read the actual note to see what it specifies.
2. Notes often repay principal plus accrued interest plus a premium, whether that premium is a fixed amount, a multiple of the amount invested, or something else. That repayment happens before any distribution to equity, treated as settling a debt.

That second point bends the waterfall structure. You still run the same core test, take the preference or convert to common, but a note that takes its preference is repaid as debt before the equity distribution, not paid through the equity waterfall. Put plainly: the note is either repaid as debt (the equivalent of taking the liquidation preference) or paid as a common shareholder (the equivalent of converting).

Where an unconverted SAFE sits in the stack

A SAFE that takes its cash-out instead of converting still has to rank somewhere in the distribution. The standard YC SAFE is explicit: in a liquidity event it sits junior to debt and to outstanding convertible notes, and it carries the same priority as standard non-participating preferred stock. So its return of purchase amount is paid inside the equity preference stack, not off the top the way a note is, and not last the way common is.

Where exactly in that stack is a judgment call, because SAFEs vary and a real cap table has rounds at different seniorities. By default a SAFE's cash-out is pari passu with the most recent equity round. You can move it: reorder the stack so it sits pari passu with a specific round, or rank it senior to all of the preferred. It stays junior to debt and notes wherever you place it.

Model this directly in the exit waterfall builder. Add the SAFE, drag the classes to set the seniority order, and watch the split change across exit scenarios.

Example models for waterfalls with unconverted convertibles

The Cap Table and Exit Waterfall Tool handles exit waterfalls across a wide range of preferred terms, but it doesn't yet have a prebuilt option for unconverted convertibles. That one you'll build by hand, following the terms above.

For a walkthrough with worked examples, see the cap table docs or a live workshop.