Understanding Waterfall Provisions In LLC Agreements

When establishing a new business, business owners typically want to ensure that any agreement they enter with other partners can offer them adequate legal and financial protection. A standard legal agreement between business partners is likely to contain waterfall provisions, which outline the distribution of assets and money between its owners.

According to the American Bar Association, waterfall provisions outline how distributions move from an investment to the business’s partners or members and are usually used in a limited liability company or partnership agreement. This is a significant element of the agreement as it outlines each individual’s reward for their contributions to the company. In this type of agreement, some partners often receive a higher proportion of the distribution, depending on the distribution tier or type used, hence why “waterfall” is part of this term. As per the Small Business Administration, these agreements between the business’s partners are operating agreements, which are contracts that outline a business’s functional and financial decisions, including the distribution of the business’s profits.

Typically, distributions from a business to its owners are proportional and depend on the initial investment. For instance, if the primary investor initially invested half of the total capital, the next investor invested a quarter of the capital, and two other investors invested an eighth of the capital, then any distributions would mirror these investments.      

In contrast, waterfall arrangements are usually tiered, with each tier outlining the distribution amounts before the distributions take place. Normally, the initial tier seeks to repay the investor for their initial investment. Then, the next tier usually involves distributing a percentage of this initial investment. After this, the operating agreement normally indicates that the investment manager can receive a substantial amount of the business’s profits. The final tier usually then involves making the remaining distributions to the other partners, with the exact amount depending on the amount of interest they have in the business. 

To foster a good relationship between those involved in the business agreement, it is vital that all parties know how the waterfall provision operates and the rights they have as the business makes the distributions. Due to this, it is key that the provision contains the correct elements, is as clear as possible, and provides adequate legal protection for everyone involved. 

When drafting waterfall provisions, it is important to make the following considerations:

• Whether the distributions between the partners are equal, or if certain partners are going to receive a greater share over others
• When the distributions are going to occur
• If specific partners are going to control the distribution amounts
• The importance of the distributions
• Whether the distributions can change as the business develops

In addition to including specific things in waterfall provisions, there are also certain things to avoid including, which can ensure that the agreement is as clear as possible.

Many distribution types can take place in the business world, so it can be useful to clarify the key differences between them. The main distribution types include:

• Proportional. For this distribution method, the business owner or investor receives a share of the profits that equate to their initial investment. The exact amount is normally calculated as a percentage and the investor can determine the amount they wish to risk.
• European-styled. This distribution method favors investors the most and involves investors receiving distributions depending on the amount they initially invested, alongside an ideal rate of return before investment managers receive their own distributions. The general partners then agree on how much each partner is going to receive, which can differ between partnership agreements.
• American-styled. This distribution method favors investment managers and is rarely used. It involves making distributions based on individual deals and enables investment managers to make poor investment decisions due to potentially only losing out on a single deal, as opposed to the whole investment.

To understand more about waterfall provisions, alongside why they are important, it is vital to learn about the various distribution tiers and some terms associated with these, including:

• General Partner. This individual is responsible for determining investment opportunities, organizing their financing, ensuring their completion, and overseeing these investments afterwards.
• Limited Partner. This individual invests their own funds into the investment plan that the general partner develops to generate a profit. Unlike a general partner, they have no control over the investment’s management.  
• Return of Capital. This distribution method involves the investors receiving the equivalent of their initial capital, alongside compensation for incurred fees, which benefits investors considerably. 
• Preferred Return. For this distribution method, the limited partners get the distributions first, with the exact returns depending on a combination of any included interest and how much they initially invested.
• Catch-up. General partners favor this distribution method, as they receive most gains until acquiring an agreed profits percentage. 
• Carried Interest. For this distribution, the general partner aims for the investment to perform well over a long period and they keep a proportion of the investment’s profits if they reach or exceed a specific percentage. 

Effective waterfall provisions also mention if in-kind contributions are permissible and, if they are, the types allowed in the provision. These distributions refer to when the business distributes property, as opposed to money. Seeing as property is not typically as replaceable as cash, determining the distribution of property and whether certain parties can select the property to distribute is essential. 

Moreover, it is crucial to consider the tax implications of including these types of distributions in the provision. Due to the complexities involved, contacting a legal professional can be an effective way of overcoming these difficulties and drafting a legally sound waterfall provision.

If starting a new business, it can be useful to seek professional legal advice to draft a waterfall distribution provision for the partnership agreement or to check the validity of an existing one. By doing this, the business owners can ensure that they receive adequate financial and legal protection.

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