Business and tax attorneys draft partnership agreements, including LLC agreements. These agreements often contain cash waterfall provisions that are designed to cause cash to be distributed a certain way until certain investors achieve a designated internal rate of return. For example, partnership waterfall provisions may provide that available cash is distributed as follows:
First, to A until A has achieved an 8% internal rate of return (IRR);
Second, 10% to B and 90% to A until A has achieved a 15% IRR;
The balance, 20% to B and 80% to A.
How do you know whether A has achieved a prescribed internal rate of return? Typically, an agreement fails to address this question. Instead, it addresses how to compute the internal rate of return. But, the partnership knows the internal rate of return. The partnership needs to know how much cash to distribute.
In 2014, Bradley Borden, a law professor at Brooklyn Law School, wrote an article entitled “Math Behind Financial Aspects of Waterfalls”. It was published in the October 20, 2014 edition of Tax Notes Today. Brad does a great job of describing financial concepts and formulae that matter in drafting partnership waterfall provisions. Moreover, he makes great drafting points for us. Principally, we should draft agreements that guide partnerships in distributing amounts. Most waterfall provisions don’t do that. They focus on IRR. They tell the partnership how to compute IRR. But, as Brad points out, we know the IRR. We don’t know the amount to distribute to meet that IRR.
To determine the amount to distribute to A in the example above, we need to determine the future value of A’s contributions as of a given time using the given IRR. To determine the future value, we need to know exactly what the IRR is. That’s our job as drafters: define exactly what IRR is – the rate, compounding period, and also how to divide the rate for mid-accrual payments. We then apply that rate to one or more present value numbers (contributions when made) and previously distributed cash amounts to determine the correct future value. That future value, applying the given IRR (i.e., the discount rate), makes the net present value of all distributions equal zero. And that’s the result that we intend to achieve when we draft waterfall provisions with reference to an IRR.
I am still thinking about drafting the partnership agreement provision that will accomplish this objective. For now, I am using something similar to what Brad provides in his article. I also am employing examples. That may be the best approach in any case. Of course, the example should be consistent with the drafted provisions. Easier said than done.
Brad’s article is worth a careful read. It’s pretty dense, but it’s also really instructive.