Glossary - Waterfall Structure
A waterfall structure is a method used in private equity and venture capital transactions that dictates the sequence and priority of distributing financial returns. The structure outlines how different stakeholders are paid out from the profits or proceeds generated by the investment or project. Typically, this involves repaying investors in a tiered system, where initial investors or those with seniority are paid before others. Waterfall structures can vary widely but generally aim to align the interests of all parties involved by setting clear expectations for the distribution of returns.
Also known as
- Distribution Waterfall
- Carried Interest Waterfall
Use cases examples
- Limited Partnership Agreement: Upon a liquidation event, the proceeds shall first be used to return all contributed capital to the Limited Partners, after which a preferred return of 8% shall be distributed, before any remaining proceeds are divided among partners according to the agreed-upon waterfall structure.
- Venture Capital Shareholders Agreement: Profits from the sale of the company will be distributed in the following order: first, to pay back all investors their initial investment; second, to distribute any agreed-upon preferred returns; and third, any remaining proceeds will be shared among the equity holders as per the waterfall provision detailed in this agreement.
Considerations for investors
- Investors should negotiate for a favorable position within the waterfall structure to maximize their potential returns, particularly in competitive investment opportunities.
- Understanding the entire capital stack and where one falls within the waterfall is crucial for assessing the risk and expected timeline for returns.
Considerations for founders
- Founders should understand where they stand in the waterfall structure to gauge their potential returns upon a successful exit.
- Negotiating the terms of the waterfall can be crucial for founders who wish to ensure they are adequately rewarded for their risk and effort, especially in scenarios where multiple rounds of funding dilute their share.
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