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Negotiating a Waterfall Provision in an LLC Agreement
Practical Law Legal Update 1-525-2681 (Approx. 7 pages)
Negotiating a Waterfall Provision in an LLC Agreement
by Practical Law Corporate & Securities
| Published on 21 May 2015 • USA (National/Federal) |
A discussion of how a sponsor or other investor in a private equity transaction may negotiate a waterfall provision in an LLC agreement.
Virtually all limited liability company agreements for companies with more than one member include distribution provisions that describe the payment of returns on the members' investments. Colloquially referred to as "waterfall provisions" or just "the waterfall," the LLC agreement's distribution provisions specify how the company is to distribute cash and other assets to its members. In so doing, the waterfall can also create different priorities of payments to LLC members, similar to dividend, redemption and liquidation payments made to the different classes of preferred and common stockholders under a corporation's certificate of incorporation.
One type of business arrangement in which waterfall provisions are often used is in investment-holding companies created for buyouts. In buyout transactions, generally an investor (or sponsor) and members of management form and become equity owners of a new investment-holding company (typically an LLC) structured as a pass-through vehicle for tax purposes. For a discussion of the structure and financing of a buyout, see Practice Note, Buyouts: Overview.
The specific layering of buyout waterfall provisions among the members is heavily negotiated and can have significant economic implications for the parties. The main negotiated issues relate to:
- The sponsor's priority return on its invested capital. A sponsor often insists on a preferred return to ensure at least some minimum return before management shares in any proceeds of the investment. The terms of the preferred return are negotiated on a case-by-case basis and are based on the underlying business of the company and the negotiation leverage of the parties involved. The yield on the preferred return generally ranges from 8% to 10% and is typically cumulative with at least annual compounding.
- Whether the waterfall provision is participating or non-participating. Whether the sponsor in a buyout receives a double-dip participation in a successful buyout is typically a heavily negotiated issue. With a non-participation feature, the management catch-up is typically a 100% catch-up rather than a lower percentage.
- The terms of the profits interest payments, including:
- whether management will be granted profits interests to share in profits of the investment. Given the importance of the management team to the success or failure of a buyout, it is fairly rare for the management team in a buyout not to receive a management carry in the form of profits interests (for further discussion, see Practice Notes, Management Equity Incentives in Buyouts: Nature of a Buyout and the Role of Management and Profits Interests). The aggregate percentage reserved for the management profits interest pool varies among sponsors and specific deals, but commonly ranges from 5% to 15%. Individual allocations from the pool usually are based on the seniority of the manager, with the most senior or key managers (such as the CEO) granted largest portions of the profits interests; and
- whether the profits interests awarded to management will be subject to vesting requirements, and if so, the terms of the vesting. It is common for profits interests awarded to management to be subject to vesting. Vesting arrangements generally are heavily negotiated and often differ among members of management. Time vesting (whether prorated or cliff vesting at the end of a period) is more common than performance vesting. It is not unusual to have a combination of time vesting and performance vesting for different portions of the carry.
For an example of a sponsor-friendly waterfall provision that ensures the sponsor gets back its entire investment (for both its preferred and common LLC units) plus a hurdle before management receives any distributions on their profits interests, see Standard Document, LLC Agreement (Multi-member, Board-Managed) (Private Equity Buyout): Section 7.02 and its related drafting notes, which provide drafting guidance and sample language for alternative distribution waterfalls.
For a more detailed discussion about structuring waterfall provisions, including those in other types of transactions (such as a private equity fund or joint venture), see Practice Note, Structuring Waterfall Provisions.
By contrast with the waterfall negotiated in a private equity investment, the distribution provisions in the LLC agreement for an operating company are frequently relatively simple. For an example of provisions providing for quarterly distributions of available cash, see Standard Document, LLC Agreement (Two Member, Managing Member-Managed): Section 6.01.