How to Structure a Deal With a Preferred Return and Waterfall
My first co-GP deal had an unusual structure. The partner put a very high preferred return on it and gave me 100% of the promote after that. He did it to protect his own return, because it was our first deal together. The deal ended up as a 78% IRR.
I tell that story because it shows how much the structure matters. Who gets paid first, how much, and who keeps the back end can change the result more than people expect. Here is how I think about setting it up. Many sponsors talk to a securities attorney about their final terms.
- 1Decide who brings what
- 2Set the preferred return
- 3Define the promote clearly
- 4Choose waterfall or high pref
- 5Price the development fee separately
- 6Vet the partner and document it
How it works, in order
Step 1. Decide who brings what
Start with roles before you talk about returns. In my first co-GP deal, I got control of the deal and put together the package. The partner brought the capital. His fund also signed on the debt, because he had a much bigger balance sheet than I did at the time. Guarantee terms vary by lender and deal. We split the development fees. Write down who finds the deal, who runs it, who funds it and who signs the loan. The return terms only make sense once everyone agrees on these roles. I also like each party to focus on what they do best, which is a big reason to partner at all.
Step 2. Set the preferred return
The person who puts in the money will often want a preferred return. In my experience, many deals are structured this way. It pays them based on the time their money is deployed. One example I mentioned was 8% on a mixed-use project. On that basis, a person gets $80,000 a year for every million they invest. Agree on the rate first, because everything after it depends on it. A higher pref protects the capital partner more. A lower one leaves more for the back end.
Step 3. Define the promote clearly
Think of the promote as the back end of the deal. It is the profit left over after the person who puts in the money has received the preferred return. This is where the operating partner earns most of the upside. Many people nod along when they hear the word and still do not know the numbers. So put the percentages on paper and walk through them together. When someone on our webinar asked what a promote was, I realized it is so second nature to me that I had skipped explaining it. Do not make that mistake with a partner.
Step 4. Choose waterfall or high pref
A typical waterfall splits profits in tiers after the pref. My first partner did something different. He set a very high preferred return and then gave me 100% of the promote after the pref. He did that to reduce the risk to his own return, since we had never worked together. You can choose either route. A standard waterfall shares the upside along the way. A high pref with a full promote gives the capital partner more certainty and the operator the whole back end. Pick the one both sides can live with.
Step 5. Price the development fee separately
Keep fees apart from the return structure. In my deal we split the development fees. Developer fees can be paid in very different ways. They can be based on the amount of time or the amount of work done. If you depend on those fees, work out with your partner what is fair before you sign. It has not been a problem in my experience, but I would still settle it early. Fee disagreements after closing can damage trust.
Step 6. Vet the partner and document it
A good structure still depends on who you are doing business with. My partner interviewed me, my development partners, my architect and my builder before he committed. I found him through CCIM, and I ran my own due diligence on him too. Build trust in both directions. Many sponsors also talk to a securities attorney about how the final agreement is written. Our first deal went so well that we are on our fifth project together, with about 125 million in total.
From my talks
"Promote, just think of it, I suppose, as the back end of the deal. The back end profit after the person that puts in."
"He did that to de-risk his own return, and that deal ended up being a 78% IRR."
More from my talks
Preferred return rates are not fixed, and nobody forces you into one number. With a single family, deal terms are often negotiable. One Family Office Club member was so confident in a deal that they offered a 30% preferred return, which is far from normal. Many deals I see use 6 or 8%, and some go over 12%. I would not copy the 30%, but it shows the rate is a negotiated term. Deal structure matters a lot. Usually the team matters even more, but you can take a good deal and ruin it with a bad structure.
"And of course, in doing any joint venture or deal with a single family, you can structure whatever deal you'd like. There was a Family Office Club member that was so confident in one of their deals, they structured a 30% preferred return, which is far from normal. Most people do 6 or 8%, or over 12%."
"Many times, deal structure matters just as much as the strategy in the deal. Usually the team matters even more, but the deal structure matters a ton. You can take a good deal and ruin it with a bad structure."
Mistakes to avoid
- Using the word promote without showing your partner the actual percentages and the order of payment.
- Setting the preferred return without thinking about who is taking the most risk on the deal.
- Mixing development fees into the return structure instead of agreeing on them separately.
- Skipping due diligence on the partner because the deal looks strong.
- Signing a structure that only one side understands.
From the source
- My first co-GP deal was a 77-unit residential mixed-use building close to downtown Nashville.
- After a high preferred return, I received 100% of the promote, and the deal ended up as a 78% IRR.
- That first partner and I are on our fifth project together, with about 125 million in total.
Sources
From Richard C. Wilson's Centimillionaire Strategies YouTube channel: Joint Venture & Co-GP Webinar - How to Close Deals with Peers & Partners in the Family Office Club, Joint Venture & Co-GP Webinar - How to Close Deals with Peers & Partners in the Family Office Club. Quotes come from the video captions, lightly edited for readability. Figures are the speakers' own estimates and experience.
General education only. Not legal, tax or investment advice.
Talk to a securities attorney to explore options around preferred return terms, promote and waterfall and debt guarantee terms. Do not use AI to write your own legal agreements.
Questions about this guide
What is a promote in a deal?
It is the back end profit left over after the person who put in the money has received their preferred return.
What is a typical preferred return?
In my example, the preferred return was 8% on a mixed-use project. That pays $80,000 per year for every million invested. Rates vary by deal.
Can a high preferred return work for both partners?
Yes. In my first deal the capital partner took a high pref to protect his return, and I received 100% of the promote after it. The deal reached a 78% IRR, and both of us did well.
Related questions
- What is a promote and how is it calculated?A promote is the back end profit that goes to the sponsor or operating partner after the investors who put in the money have received their preferred return.
- What is the difference between a convertible note and a SAFE?A convertible note is commonly described as a loan that later converts into equity, often with interest and a maturity date.
- How does a distribution waterfall work?A distribution waterfall is the order in which a deal pays out cash.
- How does revenue-based financing work for growing companies?Revenue-based financing gives a company capital in exchange for a share of its sales until the investor is repaid.
Use the data room checklist alongside this guide.