Understanding waterfall structures in a small business

What is a Waterfall Payment Structure?

The waterfall payment structure (sometimes called a waterfall model) is a common equity financing structure for entrepreneurs who are purchasing or selling businesses. A waterfall payment structure is simple in theory; when a business produces positive net income there are two things an owner can do with that money, distribute cash to shareholders or put that money back into the business. For example, if a business has positive net income of $100 and decides to put $50 back into the business and return $50 back to the shareholders, the $50 back to the shareholders represents the pool of money that can be distributed to all shareholders.

A waterfall structure may read:

1. The entrepreneur (the individual running the business) will receive 20% of the first $20, and

2. Then 50% of the remaining amount of money returned to the shareholder.

The investors receiving 80% of the first $20 and the money thereafter, could be other investors, creditors, limited partners, etc.

The purpose of the waterfall payment structure is to incentivize the entrepreneur to produce large returns (ethically). As in the example above, the entrepreneur’s return increases substantially once the business is able to return more than $20 to investors.

The waterfall payment structure is created at the start of a business, when a business has been bought or sold, or some other major triggering event that affects business operations. These waterfall payment structures are created between investors and their attorneys.

If a small business uses a waterfall payment structure for its distributions (another term used for it is a distribution waterfall), that waterfall structure will be defined in its operating agreement, term sheet or subscription agreement. Moreover, if an entrepreneur is looking to buy a business, the entrepreneur can ask if there is a waterfall structure in place and if so, what does that structure look like.

Waterfall payment structures are common in capital markets. For example, Mortgage Backed Securities (MBS) have a waterfall structure where each level in the waterfall is called a tranche. Other industries where one would see a high amount of waterfall payment structures are real estate, private equity and self-funded search acquisitions.

In real estate and private equity, the waterfall payment structure is structured in a way where the limited partner (pool of investors) receives a preferred return (sometimes called a hurdle rate) and the general partner (entrepreneur or operator of the business) will receive a significant payout when the return is greater than the preferred return.

What are Common Waterfall Structures?

There are a few common ways a waterfall payment structure can be structured. One option is through preferred participating where the preferred investor is given an option to convert its preferred shares to common shares at a specific conversion rate (or, step-up). Moreover, with preferred participating, there is typically a preferred return in the operating agreement that states that the  equity capital not yet returned to investors must make that preferred return in a single year. Sometimes, these returns are paid back on a senior and junior level (some investors will receive their return before other investors). Other times, returns will be pari-passu, which means returns will be distributed based on equity contribution from the investors.

Such a waterfall may read:

1. First, to the unit holders pro rata in proportion to the their holdings, until distributions under equal the unpaid preferred return;

2. Second, to the unit holders pro rata in proportion to their holdings, until the unreturned contribution amount (invested capital) has been reduced to zero;

3. Third, 30% to the investors and 70% to the entrepreneur, pro rata and pari passu.

In the above example, the preferred is assumed to have converted into 30% of common.

Another option could be based on a Multiple on Invested Capital (MOIC). MOIC is used to describe valuation of an investment relative to its initial cost. For example, a simple waterfall payment structure could stipulate:

1. First, until the business returns 1x of invested capital, the investors receive 80 percent of the proceeds with the entrepreneur receiving 20 percent;

2. Second, until the business returns 3x of invested capital, the investors receive 60 percent of the proceeds with the entrepreneur receiving 40 percent;

3. Third, the investors receive 30 percent of proceeds with the entrepreneur receiving 70 percent in perpetuity.

A payment structure similar to the one described above, shows that if an entrepreneur performs well her share of the distributions will grow even more.

A few other options deal with catch-ups, IRR hurdles, etc. It's important to note that the main differences between all of these structures is when an investor and entrepreneur receive their return and how those returns are determined (Internal Rate of Return (IRR), MOIC, Preferred return, etc.)

An important note, there is a difference between an American and European waterfall model. An American waterfall is typically done on a deal-by-deal basis. Therefore, returns or losses are tied to that specific investment. A European waterfall is done at the fund level; therefore returns or losses are not tied to a specific investment. It’s important to understand what type of waterfall model is used because it allows the entrepreneur to better understand the investors incentives.

Excel Example of a Waterfall Structure with Participating Preferred

As detailed below, you can see an accurate representation of how a waterfall payment structure works. Start at line item “Distributable Cash Flow”, this is the amount of cash available to the entrepreneur and investors, and move down to the Preferred Return section. The preferred return section is calculated by taking the sum of the ending capital accounts and multiplying it by the preferred return (12 percent in the below example). The preferred return amount is split based on how much capital the entrepreneur initially invested and how much capital the investors initially invested (i.e., the entrepreneur put in 22.35% of the equity in the business, therefore, receives 22.35% of the preferred return). The investor would receive the remaining preferred return.

Moving down the waterfall to the return of invested capital section, that amount is what is left over when you take Distributable Cash Flow minus Preferred Return. The entrepreneur and investors' split of the return of capital is calculated the same way as the preferred return (note this is specific to how this deal is structured).

The promote section is where the entrepreneur can receive significant return; however, the structure of the deal below stipulates that all invested capital must be returned to investors and the entrepreneur before the promote kicks in. The promote acts as an incentive for the entrepreneur to produce high returns. The example shows a simple waterfall payment structure where the investors' preferred equity converts into 40% of common ownership. Said another way, the entrepreneur will receive a majority of the distributed capital once the initial invested capital is paid back along with its preferred return.

What are the Pros and Cons of a Waterfall Structure

A few pros of a waterfall structure is that an entrepreneur has the ability to make a significant amount of money, provided they were able to generate returns greater than the preferred return or some other metric stipulated in the operating agreement or term sheet. Another advantage is that multiple investors can invest in one company at once. Moreover, an investor can be more senior in the waterfall structure or less senior in the waterfall structure, thereby giving an investor the option to invest in a business based on their risk appetite.

Downsides to the waterfall payment structure is that an entrepreneur may have to manage the payment structure given its innate complexity. If the business goes under, the entrepreneur and any investors that are not at the top of the waterfall payment structure are vulnerable to significant losses. Lastly, if payments are missed in a given year, depending on the operating agreement or term sheet, those missed payments could be cumulative. Therefore, those missed payments are paid off in future years and those missed payments take into consideration the time value of money.

How do you Manage a Waterfall Structure?

There are many ways to manage a waterfall payment structure, an entrepreneur could do it in-house or through some third party vendor. Going through a third party vendor allows an entrepreneur to focus on operations and increase returns. At Mainshares, our backoffice platform helps entrepreneurs manage waterfalls related to the investors in their small business.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.