VC Waterfalls: How Venture Funds Distribute their Returns
The Distribution Waterfall
When venture funds have proceeds to distribute, there's a structured process, or "waterfall," that defines the priority of payments to different stakeholders. This Distribution Waterfall outlines how the fund makes distributions to Limited Partners (LPs) and General Partners (GPs).
For the purposes of this post, just think of LPs as the external investors who contribute the majority of the fund's capital, while GPs are the partners who manage the fund and contribute a smaller portion.
The Types of Distributions
When the fund is ready to distribute returns, the proceeds typically flow through the following tiers:
Tier 1: Return of Invested Capital
The first priority is returning the capital invested by LPs and GPs, proportional to their contributions. This continues until all invested capital has been repaid.
For most funds, 99% of this return goes to the LPs, while 1% goes to the GPs.
Tier 2: Preferred Return (The Hurdle)
Each time the fund calls capital from its investors, it accrues a "hurdle" or Preferred Return, typically around 8%. This acts as an interest expense owed to the LPs. It can accrue either on a simple or compounded basis.
After the invested capital is fully returned (Tier 1), the next proceeds go toward paying down the accrued Preferred Return. At this stage, 100% of the distributions go to the LPs until the Preferred Return has been satisfied.
Tier 3: GP Catch-up
Once the invested capital and Preferred Return have been repaid, it's time to "catch up" the GPs to the agreed-upon 80/20 profit split. The GPs receive 100% of the next distributions until the profit allocations (Tiers 2 and 3, excluding Tier 1) reach an 80% LP/20% GP split.
Tier 4: Carried Interest
At this point, all additional profits are split 80/20 between LPs and GPs. This tier represents the ongoing division of profits—80% to LPs and 20% to GPs—once the previous tiers have been satisfied.
Why Is the Process Structured This Way?
The waterfall might seem complex, but it effectively balances the interests of both LPs and GPs. Both parties agree that the first objective is to return the invested capital and then split profits 80/20.
GPs earn a 20% share of the profits to reward the effort and expertise they bring to managing the fund, despite contributing only 1% of the capital. Meanwhile, LPs are protected by the hurdle, which ensures GPs only benefit after generating satisfactory returns. The GP catch-up tier simply restores the 80/20 balance once the Preferred Return has been met.
Case Study: Example Fund
To illustrate this process, let's walk through a fictional fund with the following parameters:
Fund Size: $101M
GP Commitment: 1% of committed capital
Carried Interest: 20%
Hurdle Rate: 8% compounded (accrued quarterly)
Term:
6-year investment period
4-year harvest period
2 optional annual extensions
Management Fee:
2.25% during investment period
2.00% during harvest period
1.75% during extension years
Target Check Sizes:
$1.2M for initial investments
$2M for follow-on investments
Let's say the fund turns $101M into $251M, a $150M increase in value.
The first $101M goes to returning the invested capital (Tier 1).
The next $18.6M goes toward satisfying the LPs' Preferred Return (Tier 2).
Then, $4.6M is distributed to the GPs in the catch-up phase (Tier 3), ensuring GPs have received 20% of all profit distributions: $4.6M/($4.6M + $18.6M) = 20%.
Finally, any remaining proceeds are split 80/20 between LPs and GPs (Tier 4: Carried Interest).