How VC Funds Work
What is a distribution waterfall?
A distribution waterfall is the contractual order in which proceeds from a VC fund are allocated between GPs and LPs. It determines who gets paid first, in what order, and under what conditions — protecting LPs and ensuring GPs only earn carry on genuine profits.
A distribution waterfall defines the priority and sequence of cash distributions from a fund. The standard VC waterfall works in layers, or "tiers," that must be satisfied before moving to the next.
The typical order is: (1) Return of capital — LPs get back 100% of their invested capital first, before any profit-sharing occurs. (2) Preferred return — LPs receive a preferred return (hurdle rate), often 8% annualized, on their capital. (3) Catch-up — GPs receive 100% of distributions until they've caught up to their 20% carry share on all profits to date. (4) Carried interest split — remaining profits split 80% LP / 20% GP.
There are two major waterfall structures. The European (or whole-fund) waterfall requires all LP capital to be returned across the entire fund before carry is paid. This is LP-friendly and eliminates most clawback risk. The American (or deal-by-deal) waterfall pays carry on a deal-by-deal basis as exits occur — more GP-friendly but requires robust clawback provisions.
The waterfall terms are negotiated in the limited partnership agreement and can have enormous financial implications. A fund that returns $500M on a $100M raise will distribute very differently than one that struggles — the waterfall structure determines exactly how those proceeds flow.
Related glossary terms
Related questions
What is carried interest and how does it work?
Carried interest is the share of a fund's profits that the general partners keep — typically 20% — and it's the primary way VC fund managers get wealthy.
What is a clawback provision in venture capital?
A clawback provision requires GPs to return previously paid carried interest to LPs if, at the end of a fund's life, the GPs were overpaid relative to the fund's total performance.