Insight

IMPORTANT CONSIDERATIONS WHEN DRAFTING WATERFALL PROVISIONS IN OPERATING AGREEMENTS

IMPORTANT CONSIDERATIONS WHEN DRAFTING WATERFALL PROVISIONS IN OPERATING AGREEMENTS

Gary R. Pannone

Gary R. Pannone

May 9, 2022 03:11 PM

There are many challenges to starting a business, and financing is the highest priority. Investors will be focused on how profits and losses are allocated and how their interest will be protected. It is crucial that a clear and valid contract that describes these allocations is created. The contractual documents and/or state law will govern how these issues are addressed and it is important to fully understand the consequences.

The distribution of assets and/or funding is generally addressed in the operating agreement if the entity is a limited liability company, or the shareholder agreement if the entity is a corporation. What is referred to as waterfall provisions relates to how and when the distribution will occur. It dictates each party’s rights under the contract and who has a priority in the distribution.

As a general proposition, members or shareholders will allocate distributions in proportion to the original investment. This means that if Investor A invested 40% of the total capital in the company, Investor B invested 30% of the total capital, Investor C invested 15% of the total capital, and Investor D invested 15% of the total capital, the distributions would be as follows:

  • Investor A would receive 40% of the distributions
  • Investor B would receive 30% of the distributions
  • Investor C would receive 15% of the distributions
  • Investor D would receive 15% of the distributions

When dealing with waterfall provisions, the difference is that the tiers would outline the amounts to be distributed to each investor before the distributions are fully disbursed. The first distribution, or tier, would be a return of capital to first repay the investor’s total investment in the company. Upon receipt of the total investment, the next tier in the waterfall would be a preferred return, which is generally a percentage of the investment paid back. The operating agreement would also state that the managing member or manager has the authority to retain a significant portion of the company’s profits in order to provide operating capital and allow it to meet its share of the gains. The final tier is to the remaining members on a pro-rata basis.

When drafting waterfall provisions, it is important that all parties understand and agree upon the structure and what rights are assigned to each shareholder. In order to avoid disputes when distributions are being made, the investors should be separately represented to mitigate confusion and ensure that each investor is fully-protected. Questions that need to be addressed include:

  • What type of distribution will be disbursed (i.e., cash flow, capital events, tax, liquidation, in-kind)?
  • Do owners share in all distributions equally or on a pro-rata basis?
  • Will there be priority rights?
  • Will there be an accrued preferred return?
  • What is the timing for distributions? Will distributions occur in specific time periods (i.e. quarterly or annually)?
  • Will specific owners or managers control the amount of distributions?

These are all very important decisions that should be clearly defined in the waterfall provisions of an operating agreement. Not only should the waterfall provisions reflect the goals of the investors and the company, but they should also anticipate major events, such as change in control and, should this occur, if there will be tag-along rights, which are pre-negotiated rights that a minority shareholder includes in their initial issuance of a company’s stock. As with all legal documents, the devil is in the details when it comes to important considerations an investor will need to make prior to agreeing to a waterfall. For further information on operating and shareholder agreements, please contact PLDO Managing Principal Gary R. Pannone at 401-824-5100 or email gpannone@pldolaw.com.

Related Articles

Protecting High-level Executives With the Apex Doctrine


by Sara Collin

The Apex Doctrine, developed to shield high-level executives from inappropriate depositions, is a beneficial asset to lawyers and clients, at least in the states where it’s been adopted.

Apex Doctrine Protects Executives

Trending Top Five: Critical Corporate Components for 2022


by Justin Smulison

It’s no longer “business as usual” for most of Corporate America. With a growing list of challenges facing the legal and financial health of many companies, we talked to several major General Counsel about the biggest areas in which businesses should remain vigilant.

Corporate Advice From General Counsel

Announcing the 2022 Best Lawyers: The Corporate Law and Commercial Litigation Issue


by Best Lawyers

The first edition of Best Lawyers: The Corporate Law and Commercial Litigation Issues features thought leadership articles from attorneys around the nation, as well as listings in more than 70 practice areas.

Corporate and Commercial Issue

Will Recent Boeing Settlements Create Tailwinds In Corporate Law?


by Justin Smulison

Prominent litigation against Boeing is setting a precedent of accountability, professionalism and commitment among company boards as well as ushering ESG further into the courtroom to help monitor and prevent safety issues.

Recent Boeing Settlements and Corporate Law

From Russia, With Law


by Best Lawyers

The bite of U.S. sanctions aside, Cleary Gottlieb partner Yulia Solomakhina sees great promise for commerce and the law as Russia increasingly embraces markets and technology.

An Interview With Cleary Gottlieb

How Technological Advances Can Help Corporate Law


by Best Lawyers

Dieter Gericke and Benjamin Leisinger discuss how being aware of technological advances helps them provide corporate financial advice.

An Interview With Homburger

How Corporate Law in France Is Navigating the Trade Wars


by Best Lawyers

Bertrand Cardi and Cyril Bonan discuss M&A, protectionism, and the trade wars' impact in France.

An Interview With Darrois Villey Maillot Broc

Merging Business and Responsibility: Gilbert + Tobin


by Best Lawyers

Attorneys Costas Condoleon and Sam Nickless from the Australian firm Gilbert + Tobin discuss the firm's 2020 award, how Australia’s Corporate Law practice is preparing for the world’s transforming economic landscape, and the international community’s demands of its businesses.

Gilbert + Tobin 2020 LFOTY Interview

A Globalized Sprint: How Japan’s Insolvency Practice Is Expanding and Preparing for the Future


by Best Lawyers

Emerging legal trends are a relished opportunity for reorganization, while natural disasters present an opportunity for innovation.

Interview with Nishimura & Asahi Law Firm

Why Cariola Díez Pérez-Cotapos Developed Its Own Legal Tech


by Best Lawyers

Juan Pablo Matus of Cariola Díez Pérez-Cotapos, 2019 "Law Firm of the Year" award for Corporate and M&A Law in Chile, discusses his firm's joint venture with Cognitiva in creating Lexnova, a legal AI system.

Cariola Díez Pérez-Cotapos Interview

Trending Articles

The Real Camille: An Interview with Johnny Depp’s Lawyer Camille Vasquez


by Rebecca Blackwell

Camille Vasquez, a young lawyer at Brown Rudnick, sat down with Best Lawyers CEO Phillip Greer to talk about her distinguished career, recently being named partner and what comes next for her.

Camille Vasquez in office

Announcing the 2022 Best Lawyers® in the United States


by Best Lawyers

The results include an elite field of top lawyers listed in the 28th Edition of The Best Lawyers in America® and in the 2nd Edition of Best Lawyers: Ones to Watch in America for 2022.

2022 Best Lawyers Listings for United States

Famous Songs Unprotected by Copyright Could Mean Royalties for Some


by Michael B. Fein

A guide to navigating copyright claims on famous songs.

Can I Sing "Happy Birthday" in Public?

Best Lawyers: Ones to Watch – The Future of Legal Talent Looks Bright


by Justin Smulison

Best Lawyers: Ones to Watch is launching its second edition in the United States, and after talking with both a company leader and esteemed lawyers on the list, the importance of this prestigious list is evident.

Best Lawyers: Ones to Watch in America 2022

Johnny Depp and Amber Heard: The Best Lawyers Honorees Behind the Litigation


by Gregory Sirico

Best Lawyers takes a look at the recognized legal talent representing Johnny Depp and Amber Heard in their ongoing defamation trial.

Lawyers for Johnny Depp and Amber Heard

Why Cariola Díez Pérez-Cotapos Developed Its Own Legal Tech


by Best Lawyers

Juan Pablo Matus of Cariola Díez Pérez-Cotapos, 2019 "Law Firm of the Year" award for Corporate and M&A Law in Chile, discusses his firm's joint venture with Cognitiva in creating Lexnova, a legal AI system.

Cariola Díez Pérez-Cotapos Interview

Choosing a Title Company: What a Seller Should Expect


by Roy D. Oppenheim

When it comes to choosing a title company, how much power exactly does a seller have?

Choosing the Title Company As Seller

Announcing the 2022 "Best Law Firms" Rankings


by Best Lawyers

The 2022 “Best Law Firms” publication includes all “Law Firm of the Year” recipients, national and metro Tier 1 ranked firms and editorial from thought leaders in the legal industry.

The 2022 Best Law Firms Awards

Announcing the 2022 Best Lawyers in Canada™


by Best Lawyers

The results include an elite field of top lawyers listed in the 16th Edition of The Best Lawyers in Canada™ and 1st Edition of Best Lawyers: Ones to Watch in Canada.

Announcing the 2022 Best Lawyers in Canada™

Education by Trial: Cultivating Legal Expertise in the Courtroom


by Margo Pierce

The intricacies of complex lawsuits require extensive knowledge of the legal precedent. But they also demand a high level of skill in every discipline needed to succeed at trial, such as analyzing technical reports and deposing expert witnesses.

Cultivating Legal Expertise in the Courtroom

Announcing The Best Lawyers in France™ 2023


by Best Lawyers

The results include an elite field of top lawyers and firms from France.

Blue, white and red strips

Wage and Overtime Laws for Truck Drivers


by Greg Mansell

For truck drivers nationwide, underpayment and overtime violations are just the beginning of a long list of problems. Below we explore the wages you are entitled to but may not be receiving.

Truck Driver Wage and Overtime Laws in the US

Caffeine Overload and DUI Tests


by Daniel Taylor

While it might come as a surprise, the over-consumption of caffeine could trigger a false positive on a breathalyzer test.

Can Caffeine Cause You to Fail DUI Test?

Announcing the 2022 Best Lawyers™ in Australia


by Best Lawyers

The results include an elite field of top lawyers and firms.

Announcing the 2022 Best Lawyers™ in Australi

Announcing The Best Lawyers in Australia™ 2023


by Best Lawyers

The results include an elite field of top lawyers and firms from Australia.

The Best Lawyers in Australia™ 2023

Announcing The Best Lawyers in The United Kingdom™ 2023


by Best Lawyers

The results include an elite field of top lawyers and firms from the United Kingdom.

The Best Lawyers in The United Kingdom 2023