VC Focus | Is there a 'market standard' distribution waterfall for international VC funds?

Within the community of fund professionals and service providers, people often refer to a "market standard waterfall" by which they usually mean a whole-fund waterfall with an 8% preferred return, a 100% general partner (GP) catch-up and a 20% carried interest.

This type of waterfall is not uncommon for venture capital (VC) funds but it is not the only formulation that is used. It is much more common to see this type of waterfall for private equity (PE) funds, especially in the mid-market and larger buy-out space, and market participants often simply assume that VC fund terms are broadly consistent with PE terms.

However, there are a range of alternatives available for VC firms.

Alternative one: no preferred return

The idea of including a preferred return in distribution waterfalls for investment funds dates back to the 1980s. The 8% figure originally corresponded to the yield on a gilt with a similar maturity to the average life of a PE fund, which back then was around six to seven years. The preferred return allowed investors to benchmark the returns of PE funds against the returns of other asset classes (such as gilts) while providing some downside protection if the funds they invested in did not meet this minimum rate of return. Somehow, that rate has stuck for 40 years! There has been lots of debate over recent years about whether 8% continues to be the appropriate rate of preferred return and sponsors have argued that 8% is too high relative to the risk-adjusted return on other assets.

In the case of VC funds, there is more variance in the level of preferred return. A good number of VC funds have come to market with a preferred return lower than 8%, and there are also a number of VC funds operating with no preferred return at all. There are a number of arguments that are typically made for dropping the preferred return (although VCs and investors are obviously not always aligned on these points). These include:

• Venture capital is an absolute return asset class and VCs should focus primarily on the total return rather than seeking a particular IRR.

• A preferred return may discourage VCs from making speculative investments (which some argue is the very nature of VC as a high risk-return asset class). This argument holds more weight at the early and seed stage where it is often not feasible to accurately project investment and portfolio level returns – let alone underwrite against a minimum internal rate of return (IRR) threshold.

• VC investments take a long time to generate revenue (especially at the early stage) and do not track a linear return profile; and they are typically made in stages with only the best performing companies receiving additional capital by way of follow-on investments. As such, VCs sometimes argue that it is unreasonable to be held to a fixed IRR from the date capital is initially deployed.

• A preferred return delays the payment of carried interest which in turn makes it harder to incentivise and motivate the investment team in the near-term, especially in a situation where a fund has a few early failures. This is more pronounced for VC where investments are often held for a long time (and compounding of the preferred return has a greater impact).

• A preferred return could lead to sub-optimal investment decisions at the beginning of the term of a fund (because sponsors might be motivated to erode the preferred return early before compounding kicks in). At the other end of a fund's life, the presence of a preferred return may discourage VCs from holding onto underperforming investments for an extended period of time even if they believe there could be potential upside further down the line.

The main justification given by investors for including a preferred return in VC funds is that they expect their investments in VC funds to deliver a reasonable IRR (as well as a healthy cash multiple) and the preferred return sets some mutual expectations around the targeted return as well as encouraging a degree of financial discipline. In cases where the fund performs badly, the preferred return acts as downside protection (which compensates investors for putting their money at risk), whereas if a fund performs well and clears the preferred return by a reasonable margin their overall returns will be unaffected.

These issues can be more pronounced for funds utilising a deal-by-deal waterfall where distributions are calculated separately for each investment by reference to the returns of the investment (rather than a whole-fund waterfall where distributions are calculated at an aggregate fund level). However, deal-by-deal waterfalls are still fairly rare and, even where they are utilised, a hybrid model is often employed whereby sponsors must cover realised losses (and sometimes unrealised losses) when making distributions.

Alternative two: multiple-based preferred return

In this scenario, a preferred return is included that is set as a multiple of an investor's contributions (the multiple is often set at 1.25X or 1.5X invested capital). Once the preferred return is cleared, these types of waterfalls typically include a 100% GP catch-up.

This model addresses some of the issues connected with alternative one given that it doesn't take into account the time value of money, but it also gives investors some downside protection around the cash multiple they will receive before the sponsor can take a profit share. While investors may not have the same comfort around IRR that a preferred return provides, they will at least have a broad idea of time horizons that VCs are working to by referring to the length of the investment period and fund term.

On the other hand, a multiple based preferred return may encourage VCs to keep under-performing investments on the balance sheet longer than they otherwise would in the hope that performance may improve.

Alternative three: ratcheted or tiered carry

A 20% carried interest rate has become ubiquitous across various asset classes (including VC, PE, opportunistic real estate and others) and, therefore, it is sometimes difficult for sponsors to move away from it. However, in the case of VC there are a few deviations from this standard in the market.

Some sponsors charge a single higher rate of carried interest (for example, a flat rate of 30% rather than 20%). In the case of VC, a single higher rate of carried interest is rare, but there are a number of examples of a tiered or ratcheted rate of carry (whereby one or more additional tiers of carried interest kicks in once certain thresholds are met). Generally, carried interest is paid at an initial rate (say 20%) until a certain return threshold is met, after which carried interest is paid at a higher rate (say 25% or 30%). The higher return threshold is generally set as either a multiple of investor contributions (which may or may not include distributions made to that point to the carried interest partner in respect of that investor) or a higher IRR. This can be combined with the other preferred return variations mentioned above.

VCs will typically justify this approach on the grounds that outsized returns should be rewarded (and actively encouraged) with an outsized profit share. VCs may also trade off including a preferred return for including a higher rate of carry, or a ratcheted or tiered carry.

Other alternatives

In addition, there are a number of other variations to the "market standard waterfall" that are less frequently utilised in the VC market but are worth considering. These include:

• Deal-by-deal and hybrid waterfalls. A deal-by-deal waterfall which is an arrangement whereby distributions are calculated separately for each investment, is sometimes referred to as a "US style" waterfall because of its prominence with US-based managers (as opposed to the "European style" whole-fund waterfall), although deal-by-deal waterfalls are becoming fairly rare even for US VC funds. Deal-by-deal waterfalls have generally become less common over recent years, and where they are used they are more commonly accompanied by a "whole fund" clawback (meaning that sponsors are required to return overpaid carry if they haven’t cleared the preferred return on a whole-fund basis). There are a few European VC firms who operate a deal-by-deal waterfall although these are in the minority and utilise the hybrid model which includes a "make whole" for realised and unrealised losses, together with a "whole fund" clawback.

• Multi-waterfall carry. This is more common for larger funds and allows investors to elect between different carry rates (for example, 20% vs 30%) often combined with alternative management fee rates.

• Preferred equity waterfall. This involves a particular investor taking a priority return before other investors receive a share of profits. This model is utilised for VC funds in the UK which take investment from the British Business Bank's Enterprise Capital Funds programme, but is quite unusual outside of that context.

• Impact funds. In the past year, there have been a few examples of VC fund waterfalls with impact-related features. These range from a portion of carried interest being paid to a charity to funds that require sponsors to donate some of their carried interest to charity if impact targets have not been met. This is an evolving area of the market and may become more prominent as impact strategies are becoming increasingly popular.

• Growth funds. In the case of VCs that have a series of growth funds sitting alongside their early-stage funds, the growth funds will sometimes have a lower rate of carried interest (particularly if the growth fund is investing into the same investments as the VC's early-stage funds).

• Side letters. Most limited partnership agreements are now drafted to permit variations to waterfalls in side letters for particular investors. The most common formulation is a straightforward discount to the headline rate of carried interest. But VCs do occasionally utilise more creative arrangements in side letters which are often fact specific. As with any side letter provisions, these types of rights need to be carefully considered in the context of the most-favoured nations provisions.

Osborne Clarke comment

A "one size fits all" approach to distribution waterfalls may not be appropriate in VC. An early-stage fund or a fund investing in very long-term investments (for example, deeptech and life sciences) may be suited to a different distribution model than a late-stage or growth capital fund. VCs raising capital primarily from high-net-worth investors that are familiar with VC may have more flexibility on terms than a fund approaching institutional investors (particularly institutional investors less experienced with VC and who may benchmark fund terms across asset classes).

First-time fund managers (particularly those raising money from institutional investors for the first time) will generally want to minimise deviations from what they perceive as market standard terms.

US-based investors with a focus on VC may be more open-minded to a deal-by-deal waterfall or variations on a preferred return than European institutional investors. However, as the US VC fund industry has matured and become more institutionalised over the last decade, pure deal-by-deal waterfalls have become less common and preferred returns, which used to be unusual in US VC funds, are coming up more often.

In the UK, removing or varying the preferred return should be carefully considered from a tax perspective as it could potentially impact the tax treatment of carried interest.

VCs should also discuss any proposed changes to their waterfall with their fund administrators, who will need to understand how the waterfall operates in practice. Including more than one variation within a waterfall in the same fund can add operational complexity.

Osborne Clarke has a market leading venture and growth capital practice across Europe, supporting investors across sectors including financial services, media and communications, life sciences and healthcare and real estate and infrastructure. If you have queries on any of the issues covered in this note please connect with one of our experts.