What is a liquidation waterfall?

The liquidation waterfall is the order in which exit proceeds are distributed: debt first, then preferred stock preferences by seniority, then common stock — with each preferred holder choosing preference or conversion, whichever pays more.

The waterfall is where terms become money: in middling exits, preferences determine who gets paid at all. Modeling the waterfall at term-sheet time is how founders understand what an exit range actually means for them.