Distribution waterfalls

In venture capital and private equity, it’s common for both private funds and private companies  to have many different investors, or equityholders. When a company completes an exit, these equityholders may all have some claim to the proceeds that the transaction generates.

For these companies and investors, planning for a potential exit can raise questions with significant financial implications. What portion of the proceeds will each equityholder receive? What is the order in which equityholders will be paid out? How might a different valuation or other exit variables impact the way that profits are distributed? 

The primary way that portfolio companies and their backers find the answers to these and related questions about the financial impact of potential exits is through distribution waterfalls. 

What is a distribution waterfall?

A distribution waterfall is a financial model that shows how the proceeds of an investment will be divided among various participants in the investment. In the context of venture capital and private equity, investors and their portfolio companies use distribution waterfall models to monitor the impact of various potential exit scenarios and to predict possible financial outcomes across a broader portfolio. 

For instance, if a company issues multiple classes of shares with different liquidation preferences, the holders of these different tiers of ownership might have different rights to receive proceeds in the event of an exit. A distribution waterfall shows how money will flow from one tier to the next. Typically, all equityholders at one tier of ownership will be fully paid out before distributions move down to the next tier. 

At the company level, distribution waterfalls show how profits from an exit will be split up among different equityholders. When these equityholders are private funds, distribution waterfalls can go a step further: They also show how an individual fund’s proceeds from an investment will be distributed among the fund’s various limited partners (LPs). 

Historically, private market participants have used custom-built spreadsheets to manually track their waterfall models. If a firm is trying to link distribution waterfalls from various companies into a single model, these can quickly grow complex, and they often rely on specialized knowledge from high-paid employees. 

In recent years, a growing number of firms and companies have begun using new software-based tools to build and manage their waterfall models as a way to streamline the modeling process and increase transparency and visibility across stakeholders. 

American vs. European waterfall structures

For private fund managers, distribution waterfalls typically come in one of two main varieties. These two waterfall structures differ in the manner and order that proceeds from the investment are distributed among LPs and the fund’s general partner (GP). 

American-style waterfall

Typically, a private investment fund returns the majority of the proceeds from its investments to its LPs. Most funds also distribute some portion of the proceeds to the GP, in the form of carried interest. The exact percentage of proceeds that goes toward carried interest is typically defined in a fund’s operating agreement. 

In an American-style waterfall, the GP receives carried interest from the fund on a deal-by-deal basis, which means they may start to receive some carry at the time of the fund’s first exit. Each time the fund realizes another investment, the waterfall is newly evaluated to determine the proper amount of carry to distribute to each party. 

European-style waterfall

In a European-style waterfall, carried interest is applied to the investment fund as a whole, not on a deal-by-deal basis. In this approach, the LPs must typically recover the entirety of their initial investment and clear any relevant hurdle rate before the GP starts to earn carried interest. 

A European-style waterfall is often seen as more favorable for LPs, because it prioritizes returns to the LP over carried interest payments to the GP. European-style waterfalls can also be easier to manage for the back offices of investment funds, as they are less likely than American-style waterfalls to incur clawback provisions (reclaiming money that was previously distributed). 

Typical waterfall structure

While fund operating agreements and the distribution waterfalls that derive from them can take many different forms, many of them follow a similar structure. Some of the  tiers of a typical waterfall distribution include: 

Return of capital (ROC)

In many cases, the first proceeds from a successful exit will go toward reimbursing the fund LPs for their initial investment. Before any equityholders begin to return a profit, the fund typically makes sure that none will take a loss. 

Preferred return

Some or all LPs in a fund may be entitled to a preferred return, also known as a preferred hurdle rate. In this case, in addition to having their initial capital returned, LPs are also promised a certain level of profit—often expressed as a percentage—before the GP begins to receive carried interest. 

Catch-up tranche

If a distribution waterfall includes a preferred return for LPs, then it may also include a catch-up tranche. Once the preferred return has been paid out, a catch-up provision calls for the GP to receive a disproportionately larger share of any ensuing profits until the point when the total return received by the GP and the LPs are once again in proportion, as defined by the operating agreement. In essence, this tranche allows the GP to “catch up” to the level of profits earned by the LP once a preferred return has been met. 

Carried interest

After fulfilling the terms of any preferred return or catch-up tranche, the remaining profits are typically divided between the GP and the LPs on whatever terms were established in the fund operating agreement. The most common split is 80% of any additional return to go toward LPs and 20% to the GP. The portion of deal proceeds that the GP receives is referred to as carried interest. 

Waterfall calculation

In most cases, the order of how different types of stakeholders will be paid out in the event  of an exit is clearly defined in a company’s operating agreement or certificate of incorporation. In some instances, however, distribution waterfalls can quickly grow more complex. In general, the more complicated a company’s cap table is, the more complicated its distribution waterfall will be. 

Distribution waterfall examples

Click the link below for a full examination of how distribution waterfalls account for deal terms and characteristics such as participating stock, waterfall breakpoints, pro rata distributions, the difference between profit interest units and capital interest units, and more.