When starting a business, determining how you will distribute profits and losses can be critical in the company’s operations. Every business and individual who enters into a contractual relationship wants to ensure that they are legally and financially protected. A clear and valid contract must be created that describes these allocations is crucial to make that happen.
Waterfall provisions describe the circumstances where there is no contract that describes the distribution system, which then allows state partnership laws to govern. If you are creating an LLC or a partnership, contact an experienced business attorney at Newburn Law to discuss your needs and review your waterfall provision to ensure that you are fully protected.
WHAT IS A WATERFALL PROVISION?
Waterfall provisions refer to the part of the contract in a partnership, corporation, or Limited Liability Company (LLC) that discusses the distribution of assets and money between the partners or holders of the company. This section of the contract is often viewed as significant as it dictates each party’s right to the reward for the work and capital put in the company. The term ‘waterfall’ indicates that certain partners or members get a priority in the distribution over others depending on the type or tier of distribution used.
As mentioned, usually members will allocate distributions in proportion to the original investment. This means that if Investor A invested 50% of the total capital in the company, Investor B invested 25% of the total capital, Investor C invested 12.5% of the total capital, and Investor D invested 12.5% of the total capital, the distributions would be as follows:
- Investor A would receive 50% of the distributions
- Investor B would receive 25% of the distributions
- Investor C would receive 12.5% of the distributions
- Investor D would receive 12.5% of the distributions
In comparison, waterfalls usually have tiers in the distribution structure. The tiers can describe the amounts that are distributed to each investor before the distributions are fully disbursed. Usually, the first tier will be for the return of capital. This means that the distributions must first go to repaying a specific investor’s total investment amount. Once that investor receives the full repayment, the next common tier is a preferred return, which is usually a percentage of the investment paid back (commonly between 5-8%). Next, operating agreements will usually state that the manager can collect a significant portion of the company’s profits to allow it to meet its share of the gains. Finally, the last tier is usually distributions to the remaining members on a pro-rated basis, which depends on their interest amounts in the company.
An example of this type of provision can be seen in the following scenario with multiple tiers of investors:
- Security Type A (typically an investor) invests $500,000 into the company.
- Security Type A will receive 100% of the distributions until the investor receives the full $500,000 back plus 6%.
- Once Security Type A receives the full $500,000 back plus 6%, then the provision can still state the Security Type A will receive a percentage of the total distributions, such as 90%, with the 10% distributed to managers.
- Finally, the waterfall provision can indicate that a specific percentage will be paid to the remaining members after a particular event happens.
The key is to determine what each tier will look like, who will be part of each tier (meaning who will have priorities), the type of priorities, whether the waterfall provision will be (1) “back-ended” or “European” or (2) “deal-by-deal,” and the timing of distributions. We dive into each of these factors below to help you and your company determine how you can utilize the waterfall provision best.
Allocation of Proceeds Example
Another example of how proceeds could be allocated in a waterfall provision is the following:
- X, Y, and Z are members of XYZ. They drafted the waterfall provision to state that X and Y will split the first $100,000 50%-50%, and then any additional distributions will be allocated 40%-40%-20%, between X, Y, and Z.
- If 50% of the company is sold to the buyer, B, for $100,000, implying that the company is valued at $200,000 and then each of X, Y, and Z sells 50% of its own interest in the company to B, then after the sale, distributions will be as follows:
- X, Y, and B will split the first $100,000 (25%-25%-50%)
- After that, X, Y, Z, and D will split proceeds 20%-20%-10%-50%
HOW ARE WATERFALL PROVISIONS DRAFTED?
In order to have a successful relationship between all parties involved, it is crucial that all individuals have a complete understanding of how the system works and what rights are assigned to them as to the distributions being made. The waterfall provisions should be drafted by someone who is well aware of what should and should not be included in that particular section of the contract to ensure full protection and no confusion for all parties.
WHAT KIND OF QUESTIONS SHOULD YOU ASK WHEN DRAFTING THE WATERFALL PROVISION?
One of the most vital steps when drafting a waterfall provision is identifying the company’s goals. The company should determine:
- Whether owners share in all of the distributions equally.
- Whether some owners have priorities over others.
- Is there an accruing preferred return or an internal rate of return (IRR)?
- Should the distributions/sharing change as economic goals are met?
- How important is the type of distribution (i.e., cash flow, capital events, tax, liquidation, in-kind)?
- When will the distributions happen?
- Will specific owners or managers control the amount of distributions?
- What are the preconditions for making distributions, if any?
Further details on the essential parts of a waterfall provision include:
- Allocation of distributions between all parties. Again, clearly describe which investors will have priority over other investors, management, and members. If you are a partnership, indicate which partners have priority to distributions over other partners and the nature of those priorities.
- When such distributions should be made. The timing for when distributions happen is crucial. The distributions can be made at specific times, such as quarterly or annually, or they can be made upon specific events occurring, such as capital events or receipts of cash.
- Amount and form of distributions. The provision should clearly state the amounts that will be distributed each time distributions are made and also how the distributions are made. Will the distributions be made from proceeds from dispositions? After expenses and obligations are paid? Include these in the provision to avoid any confusion.
- Any interest distributions. As described above, these can be the tier 2 distributions for Security Investor A.
- Any preconditions to making distributions. The provision should also state whether there are preconditions to making the distributions, such as repaying old debt, paying fees, reserves, etc.
- Any tax considerations related to the distributions.
- Also, ensure that tag-along, drag-along, and change of control provisions are consistent with the waterfall provision.
There are also certain things that should not be included in waterfall provisions in order to avoid confusion and misunderstandings. Speaking with a knowledgeable business attorney at Newburn Law can help you better understand how, or if, you should include a waterfall provision in your contract.
TYPES OF DISTRIBUTIONS
There are several different types of distributions that can occur in business and clarifying which type can make a substantial difference financially to companies and business owners.
PROPORTIONAL TO INVESTMENT
This method of distribution simply means that a member or shareholder gets a distribution equivalent to the amount that he or she invested in the business. This amount is usually calculated on a percentage basis and allows the individual to decide how much or how little he wants to risk.
EUROPEAN-STYLED
This option is most favorable to investors. It requires the investors to receive their distributions based on their invested capital plus a preferred return before general partners can receive their distributions. Then, the arrangement is made between general partners regarding how much each is getting, which can all be different, depending on the parties’ agreement. Because general partners usually do not want to wait many years in order to get their return on the investment, they favor smaller, short-term investments that allow them to get their share quicker. This type of distribution is primarily seen in venture capital funds where investments are riskier and investor-favorable marketing environments.
AMERICAN-STYLED
Unlike the European Style, the American Style makes distributions of interests on a deal-by-deal basis. It is also referred to as Deal-by-Deal without Loss Carryforward. It is uncommon and rarely used today, as it is looked at as very favorable to managers. It allows managers to make risky investments and poor decisions, as they do not have to worry about potentially losing all of their distributions but instead only have to look at one particular deal.
TIERS OF DISTRIBUTIONS
In order to fully understand waterfall provisions and their importance, it is crucial to understand the different tiers we briefly mentioned that are associated with waterfall distributions and some terminology.
GENERAL PARTNER
The general partner is another way of saying an investment manager. His or her responsibilities include identifying investment opportunities, arranging for its financing, coordinating the completion of the transaction, and managing the investment while completed.
LIMITED PARTNER
Limited partner, on the other hand, is or are individuals who are accredited investors and put in their capital in the general partner’s investment ideas in hopes of making a profit from it. They do not have control over how the investment is handled and only put in as much capital as necessary after considering the general manager’s contribution and subtracting that from the total needed for the investment. Then, the waterfall provisions in the contract govern which parties get their return first and whose distribution may be contingent on other factors.
RETURN ON CAPITAL
In this method, the investors get the initial capital equivalent, plus a refund for some of the fees and expenses. This tier is usually looked at as very favorable to investors.
PREFERRED RETURN
Under this option, the distributions go first to limited partners, giving them back returns based on their initial investment. This is often a preferred tier as it ensures limited partners that they will get a return on their investment, with some nominal interest.
CATCH-UP
This method is very favorable to general partners, as they are given most if not all of the gain until they receive a certain, earlier agreed-upon percentage of the profits.
CARRIED INTEREST
This method motivates the investment manager to ensure that the investment does well throughout the year or years. Often set around 20% of the investment, it allows the investment manager to collect that portion of the investment fund’s annual profit if the profit reaches or is beyond a certain percentage.
WHAT ARE IN-KIND DISTRIBUTIONS?
The waterfall provision should also clearly state whether in-kind provisions are permitted and, if so, what kind of in-kind distributions are allowed. In-kind distributions are when the company distributes property rather than cash. Since property usually is not as fungible as cash, it is crucial to determine what property will be distributed and whether specific individuals or investors can choose what property is distributed.
However, there are tax implications that the company should consider before allowing in-kind distributions in a waterfall provision. An experienced lawyer can help you navigate the complexities to determine the best way to draft your waterfall arrangement.
LEARN HOW AN EXPERIENCED ATTORNEY CAN HELP YOU BETTER UNDERSTAND A WATERFALL PROVISION
If you or your business needs to review a waterfall provision or require one to be written for a contract, contact our experienced legal team at Newburn Law to speak with an attorney who can help you better understand your needs and rights under will ensure that you and your business remain protected.
