Valuation Myths in VC - Part 3: Why the “EV then Waterfall” Is Not Fair Value

Continuing our mini-series on valuation myths in venture capital, we’ve already looked at cost and last price per share. Now let’s turn to another commonly used approach: the enterprise value (EV) waterfall.

At first glance, the waterfall feels logical: start with an enterprise value, then allocate it down the capital structure according to preferences and rights. But here’s the problem: the “EV then waterfall” is not consistent with IPEV or ASC 820 fair value principles (notwithstanding comments on CVM below).

Why the Waterfall Falls Short

• Choice of EV matters. Which enterprise value are you using? A DCF? A public comp? A transaction multiple? Each can produce very different outcomes, and without calibration, the waterfall becomes arbitrary.

• CVM is only for imminent exits. The Current Value Methodology (CVM) essentially a waterfall, is only appropriate when there is a clear, imminent exit (e.g., signed sale agreement, IPO process underway). Outside of that, it does not reflect market participant assumptions.

• Out-of-the-money shares get zero. The waterfall allocates value strictly based on current capital structure and rights. That means common shares or junior preferred that are “out of the money” at reporting time, are valued at zero. But in venture capital, the future matters - those shares may well be “in the money” at a higher value and possible later exit. Fair value should show that out-of-the-money shares are not worthless, but option-like instruments with real expected value.

• Later rounds may be overstated. Because the waterfall prioritizes liquidation preferences and stack order, it can give disproportionate value to the more recent rounds of preferred equity. This overweighs later investors while undervaluing earlier rounds and common equity, even though future events and outcomes could shift that balance.

IPEV and ASC 820 Guidance

Both IPEV and ASC 820 emphasize that fair value must reflect the assumptions of market participants at the measurement date. That means considering:

• The likelihood of different exit scenarios

• The optionality embedded in junior securities

• Calibration to observable market inputs

Simply running a waterfall on a single EV ignores these requirements.

The Risks of Using Waterfall as Fair Value

• Misleading reporting: Junior securities may be shown as worthless when they still have real option value.

• Compliance gaps: CVM is only compliant in the narrow case of an imminent exit.

• Loss of credibility: Sophisticated investors know that venture-backed equity is about optionality. Ignoring that undermines trust.

Closing Thought

The EV waterfall can be a useful tool for scenario analysis, but it is not fair value except in the rare case of an imminent exit.

So when you’re thinking about valuation, it helps to remember: 👉 CVM (waterfall) is only appropriate if an exit is imminent. 👉 Fair value requires calibration, scenario weighting, and recognition of optionality.

Global standards like IPEV and ASC 820 encourage us to move beyond simplistic waterfalls and toward valuations that reflect the true economics of venture-backed equity.