Meaning
Distribution schedule in a limited partnership or company articles determines the order and priority in which cash proceeds are paid out to shareholders. The equity waterfall specifies the precise sequence of payments after a liquidity event such as a sale or initial public offering. It defines the point at which different classes of capital receive their investment back and how subsequent profits are shared.
This structure is a central component of private equity and venture capital deal terms.
Liquidation Preference
Initial layers of the distribution focus on the return of the original capital to preferred investors. An equity waterfall often starts with a one times preference that ensures investors get their money back before common shareholders receive anything. Some agreements include a participation right where the investor also shares in the remaining proceeds.
This protects the downside for the provider of the capital.
Catch Up Provisions
Carried interest or performance hurdles are introduced once the initial capital and a preferred return are paid. The equity waterfall may allow the sponsors or founders to receive a disproportionate share of the profits until they reach a certain percentage of the total gains. This mechanism aligns the interests of the management with those of the investors.
It creates a powerful incentive for the team to achieve high exit values.
Calculation Complexity
Projections of final returns must account for the dilutive effects of options and warrants at every tier. The equity waterfall is modeled during the investment phase to understand how different exit valuations impact the final cash in hand for each party. Legal drafting must be precise to avoid disputes over whether a specific payment is a return of capital or a profit distribution.
These terms are found in the certificate of incorporation.
