What is Distribution Waterfall?

A distribution waterfall (DW) is the order in which returns are distributed to investors. Also called a tiered payout, it is a distribution model that sets the priority and allocation of returns between limited partners (LPs) and the general partner (GP). This mechanism is embedded in the fund's operating or partnership agreement, which defines the sequence and proportions of distributions to LPs and GPs.

The purpose of the distribution is to make both parties focus on future profits rather than short-term cash compensation. The DW takes the profit generated by the startup and distributes it according to the arrangement between the parties. The DW variations are quite flexible, meaning they might lean more towards the LPs or GPs. This makes them an efficient tool for managing the relationship and clearly sets the tone for all parties.

Distributions flow through negotiated tiers in a fixed order.

Tier 1 – Return of capital: Recovers the contributed capital, serves as the safety mechanism for the investors in case the startup is not able to make money in the long term, repays contributed capital to LPs first (the capital-back step), protecting them if later deals underperform once the investment is at least recovered.

Tier 2 – Preferred return (hurdle rate): The second tier is a minimum amount of return that needs to be realized before the following split according to the further agreement, also called a hurdle rate. It is used as a motivation tool for GPs to secure this return on top of the repayment of the initial investment. The typical rate is ~7–8% ROI. The hurdle rate is determined when setting up the VC. Academic sources describe venture investors as typically seeking returns in the range of ~5–15% above public equity benchmarks, to compensate for higher risk and illiquidity. Tightly linked to the risk profile of the investment, it is determined by considering multiple factors linked to cost, risk, or comparables. Due to its nature overlapping risk with return, it is also called a break-even yield (Kumar & Sharma, 2020). The resulting value might change across investors; however, for the startup the base is still the same - the contributed equity. It is worth noting that it is a common practice among U.S. VC funds to omit a hurdle rate from their compensation structures. By contrast, PE funds almost always include a hurdle before carried interest is paid. In the U.S. venture context, this omission reflects the highly volatile and long-term nature of VC returns, where exits are back-loaded and an annual hurdle could significantly delay or even eliminate carried interest for GPs. In Europe and the UK, venture funds are more likely to include a hurdle, though recent surveys show this still applies to only ~50% of funds. For PE funds generally, however, preferred returns remain the prevailing standard. This is due to the difference in the operational mechanism of these funds – PE bets on the high probability of more consistent return rather than a prospective high capital gain. An investment with a return exceeding the hurdle rate is generally considered sound – assessed by calculating the NPV (or the adjusted present value in highly leveraged cases such as an LBO, which highlights tax benefits) or by comparing the IRR to the hurdle rate.

Tier 3 – Catch-up (carried interest): remunerated to the fund manager and is also their primary source of income. The carried interest, or performance fee, After LPs receive capital back (and the preferred return), a catch-up may apply: in a full catch-up, 100% (or most) of further distributions go to the GP until the GP's cumulative share equals the agreed carry percentage. In a partial catch-up, only part flows to the GP. The usual targeted percentage would be ~20% of all profits to GPs – LPs get 80% of the returns according to their stake. LPs get the higher compensation to balance their initial high investment, tied in the long run, and the substantial risk. Partial catch-up can also occur; however, the full one is the most common. In some countries, co-investment is required in order to have skin in the game by investing ~2% through a co-invest vehicle, later catching up on the return with carried interest through the carry vehicle. For the GPs, carried interest represents their primary source of compensation. In most funds this is set at ~20-25% of profits, but it is important to note that carried interest is not calculated on "yearly profit", but on the overall profits of the fund after LPs have received their contributed capital (and any agreed hurdle). By contrast, the management fee, typically amounting to 1–3% of committed or invested capital, is intended to cover the ongoing operating expenses of the management company, not to provide performance-based income to the managers. Only after capital and, where applicable, the preferred return are paid back to LPs does the GP become entitled to its carried interest share. Even though in general the bigger the fund, the higher the fee, the difference in fees is not substantial. The performance fee, on the other hand, is compensation for the GPs for putting the investment together, navigating the startup, and securing the successful exit that is a source of payout for the LPs. It is considered a capital gain for tax purposes, effectively reducing the tax burden in case of successful investment. There are views that it should be taxed as income. This makes sense from the point of view that the carried interest carved out for the GPs is not calculated from the gains on their assets. On the other hand, the performance fee can be subject to reduction based on the clawback provision, or not being granted at all if the preferred return of the whole fund is not met. This effectively poses a counterargument for its classification as a capital gain instead of income.

Tier 4 – Profit split (carry split): GPs already caught up on the profits, and the carried interest is split between GPs and LPs based on the agreed percentage, e.g., ~35/65 per cent.

The mechanics behind the DW ensure that LPs get the full investment back, with the fund managers being motivated to get the job done by the management and performance fee, together constituting the two-and-twenty compensation structure. However, whether they are properly motivated not only in the short term but also in the long term depends on the horizon and the base of the payout.

Two main types of DWs are used: the American one and the European one. The main difference between them is the base for the payout.

Kumar R and Sharma M, Venture Capital Investments (First edition, SAGE Publications Pvt Ltd 2020), ch 7.

Kamps, H J, 'All venture funds use the "2 and 20" fee structure, right? Not really' (2023) https://techcrunch.com/2023/09/27/venture-fund-2-and-20/.

Heal A, 'Carried interest: private equity's tax break' (2024) https://www.ft.com/content/711f21e3-3c2a-4e12-8647-625d0925887d.

Lee E, 'Proskauer Releases European Venture Capital Fundraising Market Report' (2024) https://www.proskauer.com/report/proskauer-releases-european-venture-capital-fundraising-market-report.