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

"Lawyer of the Year"


Lawyer poses for legal headshot in purple dress

Eva Davis

Corporate Law

Los Angeles, CA

2025

"Lawyer of the Year"


Headshot of the D.C. Lawyer of the Year Honoree

Adam J. August

Corporate Law

Washington, D.C., VA

2024

A Consumer's Guide to Business Litigation: Protecting Your Rights and Interests


by Best Lawyers

Business litigation is not limited only to organizations. It’s a potentially useful option for consumers as well. Learn more about business litigation below.

Three animated businessmen review a contract on top of a magnifying glass

IN PARTNERSHIP

Beyond Business: The Personal Touch in M&A Transactions


by Justin Smulison

The stakes are always high in a business transaction because real people are often embarking on a once-in-a-lifetime event. Tiffany & Bosco M&A/Business Solutions Practice Group co-chairs Jim O’Sullivan and May Lu discuss their approach to helping business leaders make life-changing decisions and how professional partnerships strengthen their results.

Headshot of male lawyer in dark suit and red tie, and headshot of female lawyer in dark suit and gla

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

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

2025 Best Lawyers Awards Announced: Honoring Outstanding Legal Professionals Across the U.S.


by Jennifer Verta

Introducing the 31st edition of The Best Lawyers in America and the fifth edition of Best Lawyers: Ones to Watch in America.

Digital map of the United States illuminated by numerous bright lights

Unveiling the 2025 Best Lawyers Awards Canada: Celebrating Legal Excellence


by Jennifer Verta

Presenting the 19th edition of The Best Lawyers in Canada and the 4th edition of Best Lawyers: Ones to Watch in Canada.

Digital map of Canadathis on illuminated by numerous bright lights

Legal Distinction on Display: 15th Edition of The Best Lawyers in France™


by Best Lawyers

The industry’s best lawyers and firms working in France are revealed in the newly released, comprehensive the 15th Edition of The Best Lawyers in France™.

French flag in front of country's outline

Presenting the 2025 Best Lawyers Editions in Chile, Colombia, Peru and Puerto Rico


by Jennifer Verta

Celebrating top legal professionals in South America and the Caribbean.

Flags of Puerto Rico, Chile, Colombia, and Peru, representing countries featured in the Best Lawyers

Unveiling the 2025 Best Lawyers Editions in Brazil, Mexico, Portugal and South Africa


by Jennifer Verta

Best Lawyers celebrates the finest in law, reaffirming its commitment to the global legal community.

Flags of Brazil, Mexico, Portugal and South Africa, representing Best Lawyers countries

Announcing the 13th Edition of Best Lawyers Rankings in the United Kingdom


by Best Lawyers

Best Lawyers is proud to announce the newest edition of legal rankings in the United Kingdom, marking the 13th consecutive edition of awards in the country.

British flag in front of country's outline

Prop 36 California 2024: California’s Path to Stricter Sentencing and Criminal Justice Reform


by Jennifer Verta

Explore how Prop 36 could shape California's sentencing laws and justice reform.

Illustrated Hands Breaking Chains Against a Bright Red Background

Announcing the 16th Edition of the Best Lawyers in Germany Rankings


by Best Lawyers

Best Lawyers announces the 16th edition of The Best Lawyers in Germany™, featuring a unique set of rankings that highlights Germany's top legal talent.

German flag in front of country's outline

Celebrating Excellence in Law: 11th Edition of Best Lawyers in Italy™


by Best Lawyers

Best Lawyers announces the 11th edition of The Best Lawyers in Italy™, which features an elite list of awards showcasing Italy's current legal talent.

Italian flag in front of country's outline

Tampa Appeals Court ‘Sends Clear Message,” Ensuring School Tax Referendum Stays on Ballot


by Gregory Sirico

Hillsborough County's tax referendum is back on the 2024 ballot, promising $177 million for schools and empowering residents to decide the future of education.

Graduation cap in air surrounded by pencils and money

Find the Best Lawyers for Your Needs


by Jennifer Verta

Discover how Best Lawyers simplifies the attorney search process.

A focused woman with dark hair wearing a green top and beige blazer, working on a tablet in a dimly

Key Developments and Trends in U.S. Commercial Litigation


by Justin Smulison

Whether it's multibillion-dollar water cleanliness verdicts or college athletes vying for the right to compensation, the state of litigation remains strong.

Basketball sits in front of stacks of money

Woman on a Mission


by Rebecca Blackwell

Baker Botts partner and intellectual property chair Christa Brown-Sanford discusses how she juggles work, personal life, being a mentor and leadership duties.

Woman in green dress crossing her arms and posing for headshot

Best Lawyers Celebrates Women in the Law: Ninth Edition


by Alliccia Odeyemi

Released in both print and digital form, Best Lawyers Ninth Edition of Women in the Law features stories of inspiring leadership and timely legal issues.

Lawyer in green dress stands with hands on table and cityscape in background

The Human Cost


by Justin Smulison

2 new EU laws aim to reshape global business by enforcing ethical supply chains, focusing on human rights and sustainability

Worker wearing hat stands in field carrying equipemtn

Beyond the Billables


by Michele M. Jochner

In a recently conducted, comprehensive study, data reveals a plethora of hidden realities that parents working full-time in the legal industry face every day.

Women in business attire pushing stroller takes a phone call