2.3 VC The Waterfall of Distributions
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How VC Profits Flow: Understanding the Distribution Waterfall
When a Venture Capital (VC) fund successfully sells one of its startup investments for a profit, a key question arises: how is that money divided between the investors (Limited Partners or LPs) who provided the capital and the fund managers (General Partners or GPs) who found and managed the investment? The pre-agreed method for splitting these profits is called the Distribution Waterfall.​
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Think of it like a real waterfall with several pools or buckets stacked vertically. The profits (the water) must completely fill the top bucket before spilling over to fill the next one, and so on down the line. This sequential process ensures everyone gets paid in a specific, predetermined order, which is formally detailed in the fund's main legal document, the Limited Partnership Agreement (LPA).
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Here are the typical "buckets" or tiers in a standard VC distribution waterfall:
Tier 1: Return of Capital (ROC)
Who gets paid: Limited Partners (LPs)
How much: 100% of all incoming profits are distributed only to the LPs until they have received back the total amount of capital they originally paid into the fund.
Key Takeaway: LPs get all their initial investment money back first, before anyone shares significant profits.
Tier 2: Preferred Return ("Pref")
Who gets paid: Limited Partners (LPs)
How much: After all capital is returned (Tier 1 is full), 100% of profits continue to flow only to the LPs until they have achieved a minimum annual rate of return on their investment. This minimum return is called the "preferred return" or "hurdle rate," often set around 6-8% per year.
Key Takeaway: LPs not only get their money back, but they also earn a baseline profit before the GP shares significantly in the upside.
Tier 3: GP Catch-Up
Who gets paid: General Partner (GP)
How much: Once LPs have received their capital back plus their preferred return (Tiers 1 & 2 are full), the GP receives a much larger portion (often 80% or even 100%) of the subsequent profits. This continues until the GP has received distributions equivalent to their agreed-upon share (typically 20%) of the total profits distributed so far (across Tier 2 and Tier 3).
Key Takeaway: This step allows the GP to "catch up" and receive their agreed percentage share of the profits earned above the initial capital and hurdle rate.
Tier 4: Carried Interest / Final Split
Who gets paid: LP and GP
How much: After the GP catch-up (Tier 3 is full), all remaining profits are split between the LPs and the GP according to the fund's carried interest agreement. This is commonly an 80/20 split – 80% of further profits go to the LPs, and 20% goes to the GP as their "carried interest."
Key Takeaway: This is the final profit-sharing stage where both LPs and the GP participate in the ongoing success of the fund.
Why This Structure?
This tiered waterfall structure is designed to protect the LPs by ensuring they get their initial investment back plus a minimum return first. It then heavily incentivizes the GP, through the catch-up and carried interest tiers, to generate returns well above that minimum threshold, aligning the interests of both parties towards maximizing overall fund success.
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Important Variations:
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While this 4-tier structure is common, specific details can vary. Sometimes the GP catch-up works slightly differently, and there are two main overall approaches:
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"European Waterfall" (calculates distributions based on the entire fund's performance, generally more LP-friendly)
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"American Waterfall" (can calculate distributions on a deal-by-deal basis, potentially allowing GPs to receive carry sooner).
Most agreements also include "clawback" provisions, requiring GPs to return previously received carry if later fund performance doesn't ultimately support it.
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Understanding the distribution waterfall is fundamental to grasping how the economics of a VC fund work for both investors and managers.​
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Continue to our next section -> Performance Metrics
For Further Reading:
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A VC's Guide To Portfolio Construction​
This GoingVC article defines portfolio construction as the blueprint for VC success, outlining key elements like deal flow, stage focus, and investment timeline. It covers best practices (thesis-driven approach, reviews, data usage), common mistakes (over-concentration, neglecting reserves, chasing trends), and offers a step-by-step framework for building a portfolio.​
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https://www.goingvc.com/post/a-vcs-guide-to-portfolio-construction
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Understanding VC Fund Portfolio Construction
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Rundit provides a comprehensive overview of the steps involved in building a VC portfolio. It details defining the fund strategy (thesis, stage, geography, size), determining allocation (number of investments, initial vs. follow-on reserves, check size), diversification methods, sourcing/selection, monitoring, and exit planning. ​
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https://rundit.com/blog/what-is-vc-fund-portfolio-construction/
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Portfolio Construction in VC: Strategies for Smarter Investing
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VC Stack defines portfolio construction and details the key levers GPs optimize: number of investments (portfolio size), diversification strategies (sector, geography, stage, model), capital allocation per investment (tiered models, barbell approach), reserves for follow-on investments (typically 50-70%, dynamic management), and ownership targets. It also mentions emerging trends like quantitative modeling and data-driven reserves. ​
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https://www.vcstack.io/blog/portfolio-construction-in-vc
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​The Basics of Venture Capital Portfolio Construction and Management
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AngelList distinguishes between portfolio construction (designing the investment strategy) and portfolio management (tracking against the strategy). It explains construction involves key criteria like fund size, number of investments, check size/ownership, follow-on strategy, and capital recycling, explaining how these elements shape investment decisions and fund returns, influenced by the power law. ​
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https://www.angellist.com/learn/portfolio-construction
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Portfolio construction & how to model your fund
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Signature Block emphasizes the importance of portfolio construction models for fund managers. It discusses trade-offs, aligning strategy with a manager's edge, and key model drivers including diversification (concentrated vs. diversified), average check size, number of deals, management fees, follow-on reserves, dilution, and exit multiples. ​
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https://www.signatureblock.co/articles/portfolio-construction
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