Waterfall Provisions in LLC Operating Agreements: A Brief Overview
A waterfall provision is an important part of many operating agreements. A waterfall provision outlines how profits and losses are distributed among members (owners) in a limited liability company (an "LLC"). It sets the priorities for how distribution of available cash is allocated among members, ensuring that everyone is treated fairly and transparently consistent with the specific terms negotiated or agreed to by the members. This short article highlights some of the more significant aspects of waterfall provisions and why they may be important to include in your LLC's operating agreement.
I have been advising entrepreneurs, startups and investors in connection with forming, organizing and investing in limited liability companies for over 20 years. I counsel clients on all aspects of the LLC operating agreement, and I have prepared, reviewed, negotiated, analyzed, and explained operating agreements to clients in many businesses and industries. Read more about my Business Organizations practice here.
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What is a Waterfall Provision in a New York, California, or Delaware LLC?
A waterfall provision is a set of rules dictating how cash from the LLC's operations is available for distribution to the members is to be divided among and distributed to the LLC's members. It is called a “waterfall” because the profits flow down through a series of steps, each step representing a different priority for distribution. The waterfall provision sets the order in which available cash is distributed, and ensures that everyone gets their negotiated share of cash distributions and profits, regardless of their ownership percentage.
Note: there is no such thing as a "standard" or an "off-the-shelf" waterfall provision. By their nature, they are bespoke, being custom tailored to the individual needs of the specific members of your particular business at a certain time taking into account current tax laws and other unique factors. Your waterfall provision, together with the rest of your operating agreement, should be prepared by experienced legal counsel after thorough discussions. And, each member should be encouraged to have their own legal advisor, as the interests of the members in a waterfall clause are by their nature conflicting.
(Note: Distribution of cash is different from allocation of profits. In a limited liability company, profits (and losses) can be attributed to the owners for tax purposes without regard to whether cash is distributed to them. This can result in tax obligations for members for the profit that is imputed to them, even without the receipt of cash to pay their tax bills. Losses are treated similarly, allocating any tax benefits from the LLC's business losses among the members according to their respective, applicable profit percentages. In addition to being represented by an experience corporate attorney, owners and investors in LLC's should seek advice from their own certified public accountant or other professional tax advisor.)
Why are Waterfall Provisions Important in Operating Agreements?
Waterfall clauses are essential to many LLC operating agreements because they provide structure and transparency for cash distribution and profit allocation among the owners of and/or investors in the limited liability company, even before profits are earned. This clarity helps to prevent disputes and disagreements among members, which can be costly and time-consuming to resolve.
Additionally, waterfall provisions provide a mechanism for distributing profit-based cash to members in a way that aligns with their investment goals. For example, some members may prefer to receive a steady income, while others may prefer to reinvest profits in the company to fuel future growth. The waterfall provision can be tailored to meet the specific needs and preferences of each member, ensuring that everyone is happy with the distribution of profits.
How Do Waterfall Provisions Work?
The exact steps of a waterfall provision will vary depending on the operating agreement. And, waterfall provisions can be heavily negotiated among members and investors, and can occasionally become somewhat complex. But, waterfalls typically include the following distribution steps or tiers:
Return of Capital: If applicable, the first step in an LLC waterfall provision is normally to return capital to members. This means that each member will receive the amount they invested in the company, plus any accumulated interest, before any profits are distributed. Note, however, that "return of capital" can be defined or calculated in different ways, depending on the terms agreed to among the members.
Preferred Returns: If a limited liability company has a preferred membership interest class, the second step would typically provide for the distribution of any preferred returns to preferred membership interest holders. This is a predetermined rate of return (sometimes called a "hurdle rate") that is paid out before any cash distribution to common members.
Catch-Up. If applicable to the LLC, a catch-up provision next enables some members to receive cash distributions (often a very large percentage, up to 100%, of available cash) until these distribution amounts have reached a predetermined percentage of the LLC's profits.
Carried Interest. Carried interest is not common among most small-business LLC's. Carried interest provisions are most typical in real estate funds, private equity funds, and hedge funds, though they can be used in other arrangements. Carried interest is a share of profits paid to certain managers or managing members in addition to their ownership interest. It is an incentive to them to increase the value of the company overall, which, in turn, increases returns for all members.
Common Distributions: The final step is to distribute cash to common members, typically in proportion to their ownership percentage. Sometimes, the preferred members get to "double dip," sharing in the common distribution with the common members even after having received their preferred return.
It is important to note that each step in the waterfall provision may have different rules and requirements, such as minimum returns or holding periods, that must be met before cash from profits can be distributed. And note member's profits from an LLC which is taxed as a partnership are subject to extremely complex tax laws and rules. Members of an LLC should seek their own, independent tax advice from an experience tax accountant (not a bookkeeper or your Uncle Joey's "tax guy" who, he swears, is "just as good as a CPA, but a lot cheaper").
When an LLC has multiple members who are to be treated differently in the attribution of profits and the distribution of cash, the waterfall provision is an extremely important aspect of the LLC's operating agreement. The waterfall provides structure and transparency for profit and loss allocation and cash distribution, helping to prevent disputes and disagreements among members. By outlining the steps for distributing profits, waterfall provisions ensure that everyone gets a fair share of the profits and that their investment goals are met.
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