Firm News

Understanding Waterfall Provisions In LLC Agreements

Waterfall provisions are an important mechanism in LLC agreements and investments that outline profit distributions, stipulating which members receive profits and how much they get. These provisions ensure clarity and fairness for stakeholders, and understanding how they work is vital for businesses to navigate profit-sharing’s complexities and improve their financial outcomes. Learn more about this subject and its impact on business operations and investment strategies by reaching out to a seasoned New York business litigation attorney; call Schwab & Gasparini now at (914) 304-4353 in Hudson Valley, (315) 422-1333 in Syracuse, or (518) 591-4664 in Albany.

What Are LLC Agreements?

Operating agreements refer to agreed-upon legal documents drafted when forming a limited liability company, commonly called an LLC, which is a business formed under state statutes, treated by the Internal Revenue Service (IRS) as a disregarded entity, partnership, or corporation for tax purposes. Per the Small Business Administration, these documents establish an LLC’s functional and financial decision-making procedures, such as provisions, rules, and regulations, which govern a company’s internal operations so that it aligns with business owners’ needs. They are essentially contracts made between the parties holding ownership interests in the company, known as members, and typically include the following terms:

• Voting rights
• Profit and loss distributions
• Tax considerations
• Admittance of new members
• Transfer provisions
• Ownership transitions
• Proportion of ownership among members
• Member and manager benefits, powers, and duties
• How the company holds member meetings

Understanding how LLC agreements function can help clarify solutions and resolve potential disputes. 

What Are Waterfall Provisions?

Found in an LLC’s operating agreement, waterfall provisions are clauses in these contracts discussing money and asset distribution between the company’s members. These clauses are highly significant since they dictate the rewards received by each party for the capital and work they have invested into the business, with the word “waterfall” indicating that specific members have a higher distribution priority over other parties, depending on which distribution tier or type the members have agreed upon when signing the operating agreement.

In non-waterfall arrangements, members allocate distributions according to how much capital they have invested into the company; for instance, if one investor invested half the capital and two other investors invested 25% each, then the first investor receives half of the distributions and the other two receive a quarter each. By contrast, a waterfall distribution structure typically contains tiers, describing the funds to distribute to each member. Usually, distributions first repay a member’s capital investment, then typically a proportion of the repaid investment, followed by a significant distribution to managers, and finally, the outstanding members receive pro-rated distributions, depending on their level of interest in the business.

The Importance of Waterfall Provisions in LLC Agreements

Waterfall clauses are helpful to include in LLC operating agreements since they offer transparency and structure for profit allocation and cash distribution among LLC members before the earning of profits, which assists in avoiding time-consuming and costly member disputes. In addition, these provisions allow for tailored profit distributions to members based on their investment objectives and other specific needs. For instance, some members might want distributions that provide a regular income, whereas others could prefer reinvesting profits into the business to fuel growth and greater returns in the future.

To find out more about waterfall provisions in LLC agreements, contact a knowledgeable New York business litigation lawyer. Call Schwab & Gasparini’s Syracuse, Albany, White Plains, or Hudson Valley office to see how they can help businesses with their legal issues.

Which Factors Impact the Outlining of Waterfall Provisions?

Several factors impact the splitting of an LLC’s profits and losses and, therefore, the waterfall clauses. These include the following:

 

• Contributions of members: Member contributions typically define their share of the company’s profits. Often, waterfall clauses benefit an LLC’s members who provide the business with more capital.

• Investment recovery: Waterfall clauses usually allow members to recover their original investment prior to the sharing of profits.

• Distribution priority: Sometimes, LLC members may agree to prioritize distributions to certain members before others, such as senior members who have made considerable monetary contributions.

• Member interests: Profit distributions often align with the ownership interests of members, addressing diverse member expectations, including management involvement, share percentage, and voting rights.

• Tax consequences: LLCs may design waterfall clauses to minimize the taxes incurred by members when sharing profits.

• Timing of distributions: Waterfall clauses may set out when distributions take place to avoid ambiguity, such as when the company disposes of assets, attains a certain level of profit, or faces liquidation.

Outlining waterfall provisions as a business owner can be complex, but understanding the impact of New York law can help avoid legal issues.

Waterfall Distribution Types and Tiers in LLC Agreements

The contents of waterfall clauses can vary significantly depending on an LLC’s unique requirements and the type of distribution structure used. Below is an overview of the different waterfall distribution types and tiers featured in LLC operating agreements.

Types of Waterfall Provisions in LLC Agreements

A simple distribution disperses profits and losses in accordance with members’ capital contributions or ownership percentages. This is a simple approach often used when members have made equal or close to equal investments into the firm. In addition, there is a preferred return distribution type, commonly used where certain members have invested in the business in much larger amounts compared to other members, where the higher contributing members receive returns before other parties.

Another type of distribution, known as a catch-up distribution, involves allocating a proportion of profits to non-preferred members to allow them to catch up with preferred members who have already received their returns, enabling all members to benefit from the company’s success. Finally, tiered distribution entails establishing several distribution tiers with specific conditions to meet before moving to the following tier, which fosters orderly and fair distributions. Waterfall clauses have tiers outlining distribution priority, including the following.

Capital Contribution Returns

The initial tier of a waterfall distribution usually relates to repaying members who contributed capital. This happens before profit distribution to allow members to recover their finances. This payment is generally not taxable and is mainly considered a return of assets to the original owner.

Preferred Return

This tier permits eligible members to receive their capital contributions prior to distributing funds to lower-ranking members. The preferred return tier rewards members for making significant contributions to the company first.

Profit Sharing

Following satisfactory capital returns and paying preferred members higher returns, the company shares the remaining profits with other members. How a company does this depends on the specific profit-sharing terms stipulated in the waterfall clause, often done proportionally per member contributions, and could take place after the business reaches a certain profit threshold.

Residual Distribution

Finally, the business may use excess funds to enable low-ranking members to catch up with preferred members. Then, the company may distribute residual funds per members’ ownership interests.

In-Kind Contributions Explained

In-kind contributions are member contributions to an LLC that are not cash, such as equipment, land, and IP. Waterfall clauses can accommodate these contributions by giving them a value and including them in distribution arrangements. To avoid disputes, it is necessary to assign correct values to these assets and provide adequate rewards to members for the donation of these contributions, which may lead to waterfall clauses giving preference to members making substantial in-kind contributions due to these assets benefiting the company.

Contact an Experienced New York Business Litigation Attorney To Learn More

When starting a new company, business owners usually seek agreements with partners that provide sufficient financial and legal protection. Such agreements are likely to include waterfall provisions, which can lead to stress and frustration for business owners to manage and draft. Consulting with a knowledgeable New York business litigation attorney to draft these provisions or, if already drafted, check their validity, can remove this burden and help the business thrive. Schedule a preliminary consultation with Schwab & Gasparini today by calling our Albany location at (518) 591-4664, our Hudson Valley or White Plains offices at (914) 304-4353, or our Syracuse site at (315) 422-1333.

Mon Dec 1 2025, 12:00am