How does a distribution waterfall work?
Short answer
A distribution waterfall is the order in which a deal pays out cash. Money fills one tier before it moves to the next. A common order is return of capital first, then a preferred return, then a split between investors and the sponsor. The exact tiers vary from deal to deal, and many sponsors talk to a securities attorney about how to put them in writing.
Think of a waterfall as a set of buckets stacked down a hill. Cash from the deal fills the top bucket first. Only when it is full does water spill into the next one. Each bucket has its own rule about who gets paid and how much.
The tiers most waterfalls use
Every deal writes its own version, but many follow the same general pattern. Here is a common one:
- Tier one returns the investors' original capital to them.
- Tier two pays a preferred return to investors, which is often a set annual rate paid before the sponsor shares in profit.
- Tier three may include a catch-up, where the sponsor receives a larger share until it reaches an agreed point.
- Final tier splits the remaining profit between investors and the sponsor at an agreed ratio.
Some waterfalls add hurdles. A hurdle is a return target that investors must hit before the split changes in the sponsor's favor. Here is a simple, hypothetical case. If a deal returns more than the investors' capital plus their preferred return, the extra cash lands in the later tiers and gets divided by the agreed ratio. If it returns less, the later tiers may receive little or nothing.
Why the order matters more than the headline price
The order of payment decides who actually takes money home. A big sale price does not mean everyone at the table gets rich. I saw this come up at one of our events.
"It came up earlier on one panel that you could sell your company for $90 and only take home $2."
That example was about preferred equity sitting ahead of founders. The same logic applies inside any waterfall. Whoever is paid first gets paid before everyone below them. If you are the sponsor, your pay can shrink fast when the top tiers are large.
In this event recap I talk about why deal structure can matter more than strategy, including the FanDuel example.
Summary and key takeaways from this video
How I think about setting one up
In my experience, many people who raise capital ask their attorney what structure to use and then accept the usual answer. I would rather you understand the tiers before you sign anything.
Ask a few plain questions. Who gets paid first? What return do investors need before I share in profit? What happens if the deal returns less than planned? Would an investor read this and feel treated fairly? A waterfall that looks fair to both sides may be easier to raise money with.
At Family Office Club we spend a lot of time on deal structuring because it is one of the things sophisticated investors look at closely. A clear, simple waterfall also shows you thought the deal through. Keep it as plain as the deal allows.
Rules about what can be offered and to whom vary depending on how a deal is raised. Waterfall terms can also raise legal and tax questions. Many sponsors talk to a securities attorney and a tax advisor about these questions. This page is education, not legal, tax or investment advice.
Facts and figures
- A panel at one of our events noted a company could sell for $90 and the owner might take home only $2 because of the deal structure.
- I mentioned FanDuel as an example where, as I understand it, heavy investor preferences meant the founders took home far less than the headline sale price suggested.
- In my experience, many people who raise capital ask their attorney what structure to use and take the usual answer.
Sources
From Richard C. Wilson's Centimillionaire Strategies YouTube channel: Top Investor Insights from the Event: Deal Structuring, Distribution & What Actually Wins. 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 waterfall drafting, investor eligibility rules and tax treatment of distributions. Do not use AI to write your own legal agreements.
Where to start
- 1Write down every tier in plain English before you talk to your attorney.
- 2Run a few outcome cases: a great exit, an average one and a weak one.
- 3Check who is paid first in each case and whether that feels fair.
- 4Consider talking to a securities attorney about how the waterfall language is drafted and reviewed.
- 5Show the tiers to a trusted investor and ask what is unclear.
People also ask
What is a preferred return in a waterfall?
It is often a set annual rate that investors receive before the sponsor shares in profit. The rate and how it accrues are usually negotiated between the parties.
Is a waterfall the same as a profit split?
Not quite. A profit split is usually one tier at the bottom of the waterfall. The waterfall also covers the earlier tiers, such as return of capital and the preferred return.
Who should write the waterfall terms?
Many sponsors talk to a securities attorney about how to draft them. I suggest you think through the business terms first, so you go into that conversation with a clear plan.
Related questions
- What is a most favored nation clause for investors?A most favored nation clause, or MFN, says that if the sponsor gives another investor better terms, you can ask for those terms too.
- 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.
- How do I structure an earnout in an acquisition?Tie part of the purchase price to how the business performs after closing.
- What is preferred equity and how does it work?Preferred equity sits in a deal's capital stack between the bank loan and the common equity.
Work through it with the pitch deck grader. See all deal structuring resources.