The Waterfall Model in Venture Capital, Explained

What is the Waterfall Model?

The waterfall model is the structured sequence in which profits from a venture capital fund are distributed among its investors. Think of it like a layered cake where returns cascade through tiers. At each stage, profits are allocated based on predefined rules until everyone has received their agreed share.

Breaking Down the Waterfall Structure: USRV Ventures Example

Let’s walk through how the waterfall structure works using a hypothetical $100 million fund raised by USRV Ventures.

1. Return of Capital

The first priority is ensuring LPs get their money back. If the fund generates $100 million in returns, every dollar flows back to LPs before anyone sees profit. This ensures that the capital is preserved before profits are shared.

2. Preferred Return (Hurdle Rate)

After the initial capital is returned, LPs often receive a guaranteed return (often around 7%) for the time their money was locked up. If the hurdle rate is 7% on a $100 million investment, LPs will receive $7 million annually before any profits are shared further.

3. GP Catch-Up

Once LPs have received both their initial investment and the preferred return, GPs are compensated for their role in value creation. The catch-up phase allows GPs to receive a portion of profits until they reach the agreed share—often balancing out to the standard 80/20 profit split.

4. Carried Interest (Final Profit Sharing)

Finally, after the catch-up phase, the remaining profits are split, typically 80% to LPs and 20% to GPs. If $50 million in profits remain, $40 million would go to LPs, while GPs would receive $10 million.

European vs. American Waterfall Structures

The mechanics of how profits flow can vary based on the type of waterfall structure chosen.

European Waterfall

• Principle: LPs must fully recover their entire capital across the fund before GPs see carried interest.
• Pros: Stronger protection for LPs, ensuring longer-term accountability.
• Cons: GPs may face delayed incentives, reducing short-term motivation.

American Waterfall

• Principle: Profits are distributed deal by deal. GPs can claim carried interest from successful exits even if the full fund hasn’t repaid LPs.
• Pros: Faster GP payouts, encouraging aggressive investments and earlier liquidity.
• Cons: Riskier for LPs, as early GP payouts could reduce overall returns if some investments fail.

Why the Waterfall Model Matters

The waterfall model shapes the behavior and relationships within a fund. Here’s why it’s so critical:

1. Clearly defined stages ensure all stakeholders understand how profits will be distributed, minimizing disputes.
2. GPs are rewarded only after LPs are protected, keeping the focus on long-term value creation.
3. By prioritizing capital return, the model ensures LPs bear less risk.

The waterfall model is a critical piece of venture capital success. When structured correctly, it aligns everyone’s incentives, protects investors, and rewards fund managers for genuine performance.

The best funds ensure that everyone involved benefits fairly. A well-designed waterfall keeps capital flowing smoothly, enabling long-term partnerships and sustained success.

The lesson? Fairness in venture capital isn’t a constraint. It’s the foundation of sustainable growth and lasting relationships.

About Taghash

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