If several business owners start a new company together, everyone involved usually wants an effective partnership agreement that will provide good financial and legal protection for each partner. Many of these agreements will include a waterfall provision, which outlines how the business distributes its assets among the different owners. To better understand waterfall provisions in LLC agreements or to get help drafting your next partnership agreement, consider contacting Polymath Legal PC by calling (833) 931-6418 to schedule a consultation.
What Is a Waterfall Provision?
A waterfall provision is a segment of a limited liability company (LLC), corporation, or partnership agreement that outlines how the business intends to distribute its money and assets among the company’s shareholders or partners. According to the United States Small Business Administration, these provisions are found in operating agreements. They outline how the company plans to function, including how it intends to distribute its profits and losses.
Waterfall provisions are significant because they state how each party is going to benefit from his or her contribution to the business. When businesses operate without a waterfall provision, the company partners or shareholders receive distributions that are proportional to their original investments. Conversely, when operating agreements contain waterfall provisions, these distributions depend on the tiers, which outline the exact amounts to distribute to the investors.
What are the Common Tiers in a Waterfall Distribution?
While it is possible to fully customize the tiers within a waterfall distribution, there are usually the following four tiers in these provisions:
- Return of capital
- Preferred return
- Catch-up tranche
- Carried interest
Return of Capital
This tier focuses on return of capital (ROC), allowing the investors to receive payments until they recover the entirety of their initial investments. For instance, if each investor provided $100,000 in initial capital, this provision allocates distributions up to $100,000 each before moving on to the next tier.
Preferred Return
A preferred return waterfall distribution allocates the outstanding distributions to the partners until they have received their predefined preferred return for their original investment. Typically, the rate for this return is between 7 percent and 9 percent.
Catch-up Tranche
The next common tier in a waterfall provision is the catch-up tranche. The general partner, the individual who manages the distribution, receives distributions until he or she gains a specific proportion of the profits. Normally, waterfall provisions include this tier to incentivize the person who manages the waterfall distribution to achieve maximum returns for the investors.
Carried Interest
Following the catch-up tranche is the carried interest tier in which the general partner continues to receive a specific percentage of the remaining distributions. Normally, this percentage matches the proportion of the profits allocated to the fund’s sponsor in the previous tier.
Other Features
The hurdle rate, or minimum return rate, for the provision may involve tiers, depending on any profits made by the general partners. Usually, the minimum return rate increases as the general partners’ profit levels increase from the distribution.
Waterfall provisions may also include “clawback” features. According to the American Bar Association, these features take effect when unexpected events happen regarding the distribution and are intended to protect the investors’ interests.
Understanding the Different Types of Waterfall Structures
There are three common waterfall structures, which may either favor the investors or the general partners. These structures include:
- American
- European (or global)
- Proportional
American Structure
The American structure involves allocating distributions via deals rather than at a fund level. The risk of any investments made is spread over the deals, which benefits the fund’s general partners. With the American structure, the general partners receive their distributions before the other partners are paid back their capital investments alongside their preferred returns.
European (Global) Structure
The European structure, which is sometimes known as a global structure, allocates distributions at a fund level. Investors receive all the distributions, and the fund’s manager gains no profits until after the investors are repaid the capital they invested alongside their preferred returns. A European structure primarily benefits the investors, as the fund’s manager may not receive any profits for many years after the distribution begins.
Proportional Structure
A proportional waterfall structure allows the company owners or investors to receive a segment of the business’s profits that is equal to what they first invested. For this structure, the distribution is normally a percentage value. Additionally, the investors may decide how much of their initial investment they would like to risk.
What Are In-Kind Contributions?
An in-kind contribution is when a company distributes property instead of money. Often, a waterfall provision may outline whether an in-kind contribution is permissible and what the allowed property types are. A seasoned attorney can assist with defining in-kind contributions and navigating any challenges, including tax requirements. Additionally, an attorney at Polymath Legal PC can help by explaining or reviewing waterfall provisions in LLC agreements.
Importance of Effective Waterfall Provisions
Effective waterfall provisions are important, as they provide clarity for everyone who is involved in a partnership agreement and help to create a positive relationship among the stakeholders. A good waterfall provision informs all parties of the details of the operation and their distribution rights.
To create an effective waterfall distribution, it is important to consider whether the partners may receive equal distributions or whether some partners may receive a larger proportion of these distributions. Additionally, arrangements must be made for when the distributions will take place and if certain partners may control these distributions. Furthermore, when planning your waterfall provisions, think about whether the distributions may change over time as the company grows.
Contact an Attorney for Help with LLC Waterfall Provisions
For new businesses that have multiple partners, it can often be beneficial to set up waterfall provisions in LLC agreements. A knowledgeable legal professional can help to select the most appropriate provisions for your company. He or she can also help adjust a current waterfall distribution or create an effective waterfall provision to provide adequate legal and financial protections for all parties to the agreement. Consider contacting an experienced attorney at Polymath Legal PC for answers to your waterfall provision questions by calling (833) 931-6418 to schedule a consultation.