The Beginner’s Guide to a Distribution Waterfall

 

A distribution waterfall is the order of operations for how cash flows out of the company and reaches its owners. It answers four questions in this order:

1. Who gets paid first?
   
   
2. How much do they get before anyone else participates?
   
   
3. What happens after priority pay is satisfied?
   
   
4. How do splits change once milestones (hurdles) are hit?
   
   

Keep it as short as possible and no shorter. In most SMB acquisitions using an LLC/partnership structure, the clean version looks like this:

 

• Preferred return to investors (e.g., 8% per year on unreturned capital)
  
  
• Return of contributed capital to those same investors
  
  
• Split of remaining cash flow (e.g., 80/20 to a hurdle, then 70/30 thereafter)
  
  

That’s it. Four lines you can explain on a napkin. If your waterfall can’t be explained in a paragraph, it’s probably too clever.

 

Why Waterfall Design Matters Right Now

 

Deals are competitive. Sellers want certainty. Lenders want simplicity. Investors want protection with upside. A clean waterfall lowers your cost of capital and shortens time to close because everyone can model it quickly and agree before emotions get involved. It also reduces post-close friction—no silent assumptions, no side promises, no “handshake economics.”

 

A Simple, Honest Waterfall You Can Deploy Today

 

Use this template as your default and only deviate with intent.

 

Step 1: Preferred Return (“Pref”)

• Set a straightforward rate—6–10% is typical in SMB.
  
  
• Choose simple cumulative over compounding to avoid surprise math.
  
  
• Accrues only on unreturned investor capital.
  
  

Step 2: Return of Capital

• After paying all accrued pref, return 100% of each investor’s contributed capital until everyone’s capital accounts read zero.
  
  

Step 3: Profit Split to First Hurdle

• Split remaining cash 80% to investors / 20% to sponsor until investors reach a clearly defined milestone:
  
  
  • either a multiple on invested capital (e.g., 1.5x or 2.0x), or
    
    
  • an IRR hurdle (e.g., 15%).
    
    
• Pick one. Multiples are simpler for SMBs; IRR requires precise timing and can be gamed with early distributions.
  
  

Step 4: Profit Split Above Hurdle

• After the hurdle, split 70% to investors / 30% to sponsor on all further profits.
  
  

Plain-English notes

• “Sponsor” means you or your GP entity.
  
  
• The pref is not a guarantee; it’s a priority claim on available distributable cash.
  
  
• If the business never throws enough cash to cover the pref, the shortfall accumulates and is paid at exit before splits.
  
  
• No hidden catch-ups or side pockets. If you add a sponsor catch-up, state it plainly and model the effect.
  
  

 

Worked Example (So You Can See the Money Move)

 

Assume investors contribute $1,000,000. Pref is 8% simple, and the hold period is two years. On exit, the SPV has $1,400,000 to distribute after all debt, taxes, and fees.

1. Pref first: 8% × $1,000,000 × 2 years = $160,000 to investors.
   Remaining: $1,400,000 − $160,000 = $1,240,000.
   
   
2. Return of capital: $1,000,000 back to investors.
   Remaining: $1,240,000 − $1,000,000 = $240,000.
   
   
3. Profit split to first hurdle: say the hurdle is 1.5x MOIC for investors.
   
   

• Investors have received $1,160,000 so far ($160,000 pref + $1,000,000 capital).
  
  
• 1.5x on $1,000,000 = $1,500,000.
  
  
• Amount needed to reach the hurdle: $1,500,000 − $1,160,000 = $340,000.
  
  
• But there’s only $240,000 left. So all of it is split 80/20:
  
  
  • Investors get $192,000, sponsor gets $48,000.
    
    

Final totals

• Investors receive: $160,000 + $1,000,000 + $192,000 = $1,352,000 (1.352x MOIC)
  
  
• Sponsor receives: $48,000
  
  

Because the hurdle wasn’t reached, the 70/30 tier never kicked in. The rules did their job: investors got priority safety, you captured promote only on true profits.

 

Change the outcome, not the rules. If you want more promote, grow EBITDA or hold longer—don’t “optimize” the waterfall to squeeze the people writing checks.

 

Preferred Stock vs. Preferred Equity vs. Common: Use the Right Tool

 

In SMB, you’ll usually see preferred equity (preferred units) in an LLC rather than corporate preferred stock. The function is similar—priority in distributions and liquidation—but the documents differ.

• Preferred equity fits LLC/partnership tax treatment and integrates cleanly with waterfalls. Use when investors need downside protection and you want tax pass-through.
  
  
• Preferred stock fits C-corp structures. Use when you’re targeting institutional or venture-style investors who require stock class mechanics.
  
  
• Common equity is what the sponsor should own for promote and alignment; it sits behind the preferred in the waterfall.
  
  

Choose the instrument that matches your entity type and investor expectations. Don’t bolt corporate preferred into an LLC or vice versa just because a template you found online looked elegant.

 

When to Add a Hurdle (And When Not To)

 

Use a single hurdle when you’re raising from angels, family offices, or search-fund style LPs. It’s clear and enough to align interests.

Add a second hurdle (e.g., 80/20 to 1.5x, then 70/30 to 2.0x, then 60/40 thereafter) only if:

• You have professional LPs who expect tiered promotes, and
  
  
• The extra complexity won’t slow the close or confuse lenders, and
  
  
• You can explain it in 60 seconds.
  

If it takes a spreadsheet and a TED talk to describe your promotes, you’re over-engineering.

 

Keep the Waterfall Bankable

 

Lenders don’t approve waterfalls, but they live with the behavior waterfalls create. Avoid structures that make underwriters flinch.

• No disguised debt. A pref is a priority claim, not a guaranteed coupon. Don’t write it like a loan in equity clothing.
  
  
• Respect covenants. Your waterfall can’t ignore working capital or debt service. Distributable cash is what remains after both.
  
  
• Mind personal guarantees. If your lender requires PGs from 20%+ owners, design your cap table so you know who’s signing.
  
  

A bank-friendly waterfall signals discipline. Discipline lowers your rate and shortens underwriting.

 

The Sponsor’s Dilemma: Catch-Up or No Catch-Up?

 

A catch-up clause gives the sponsor an accelerated share of profits after the pref so the sponsor “catches up” to the intended split before regular sharing continues. It can be fair—and it can be a minefield.

• Use a small catch-up only if your LPs are sophisticated and they expect it.
  
  
• Make it explicit and short (e.g., “Sponsor receives 30% of distributable cash after pref and ROC until aggregate sponsor share equals the intended split; thereafter share 70/30”).
  
  
• Model and share examples so no one is surprised.
  
  

If you’re unsure, skip the catch-up. You’ll earn more goodwill closing fast than you’ll earn in a few extra points of promote.

 

The One-Page Term Sheet for Waterfalls

 

Put this into your SPV docs, operating agreement, or investor memo. Keep it tight.

 

Priority of Distributions

1. Preferred Return: 8% simple, cumulative, on unreturned invested capital to Class A.
   
   
2. Return of Capital: 100% to Class A until all contributed capital is returned.
   
   
3. Profit Split to Hurdle: 80% to Class A / 20% to Manager until Class A achieves 1.5x MOIC.
   
   
4. Profit Split Above Hurdle: 70% to Class A / 30% to Manager thereafter.
   
   
5. Timing: Quarterly, subject to lender covenants, working-capital needs, and Manager’s reasonable reserves.
   
   
6. Change Control: Any change requires consent of Manager and a majority-in-interest of Class A.
   
   

You can add tax distributions if needed, but don’t let “tax” become a backdoor waterfall. Tax distributions should be advances against future amounts, not extras.

 

Common Mistakes (And How to Avoid Them)

• Compounding the pref by accident. If you mean simple cumulative, write “simple cumulative.”
  
  
• Multiple bespoke side letters. One waterfall for all. If you need different economics for a strategic investor, put them in a separate class and disclose it to everyone.
  
  
• IRR gaming. Don’t stretch to hit IRR hurdles by starving working capital. Healthy companies pay more at exit.
  
  
• Undefined “distributable cash.” Define it: after debt service, after lender reserves, after reasonable operating reserves.
  
  
• Waterfall without a budget. Numbers beat narratives. Pair the waterfall with a 24-month cash model and sensitivity table.
  
  

 

When to Deviate From the Template

• Turnaround or distressed buy: Increase the pref or add a second hurdle to compensate investors for higher risk.
  
  
• Asset-light, high-growth play: Lower the pref and skew the promote to emphasize upside for both sides.
  
  
• Real estate + opco stack: Separate waterfalls (EPC and OC) with arm’s-length lease terms, then a consolidated view for the combined return.
  
  

Change the terms to reflect risk, not to manufacture returns on paper.

 

 

Quick Answers to Questions I Hear Every Week

 

Is an 8% pref standard?
There’s no law, but 6–10% simple is common in SMB. Let cash flow, risk, and hold period drive the number.

 

Do I owe pref if there’s no cash?
It accrues and comes out of future distributable cash and exit proceeds. You’re not writing checks from your pocket unless you promised to.

 

Can the sponsor get paid along the way?
Yes—via the split tiers after pref and ROC are met, and via a reasonable management fee if disclosed. Don’t try to sneak economics into fees.

 

Should I use IRR or MOIC hurdles?
Use MOIC for simplicity unless you have institutional LPs who demand IRR. If you pick IRR, model timing precisely and share that model.

 

What happens at a loss?
If there are no profits after pref and ROC, promotes don’t trigger. Priority protection means investors recover first.

 

 

If You Remember Nothing Else

• Preferred return first, return of capital second, simple splits after.
  
  
• One hurdle is plenty for most SMB deals.
  
  
• Use MOIC (Multiple On Invested Capital) unless you need IRR.
  
  
• Put working capital and debt service ahead of distributions.
  
  
• Write it so a smart teenager can explain it. If they can’t, you can’t.
  
  

Parable: The Millwright’s Weir (An Acquisition Artistry Story)

 

A millwright built a waterwheel on a busy river.

 

The wheel turned, but some days the current flooded the troughs and other days the paddles ran dry.

 

The mill stuttered, and the village argued about whose grain should be ground first.

 

An old engineer visited and walked the riverbank in silence. He didn’t touch the wheel.

 

He built a weir—a simple stepped gate upstream.

 

The gate channeled the flow: first a steady rivulet to keep the wheel turning, then a wider stream once the paddles caught, and finally a spillway for the surplus.

 

The wheel spun smoothly. The mill ground more grain than ever. The arguments stopped because the river now had rules.

 

Your waterfall is the weir. The wheel is your operating company; the river is cash flow.

 

First, a steady stream to protect your investors, then a fair share once safety is covered, and only then the surplus to reward the builder.

 

That is acquisition artistry: direct the flow with simple, honest rules, and the machine will do the rest.