So how does a waterfall work in a syndication or a fund? What are the steps? What are the different kinds of things that can go on, that's what we're gonna talk about. Thought it'd be helpful to have a visual representation of what exactly happens in a waterfall and how to think about it. That makes it real clear, because it really isn't very complicated. And but seeing it on paper sometimes can make all the difference in the world. So let's go to the handy
whiteboard. So let's talk first about a direct investment deal where we know what it is, let's say it's a piece of real estate. Most of my clients are real estate, but we have a number of private equity firms, hedge funds, businesses, all sorts of other people that raise capital, but most are in real estate. So let's stick with that. So we've got a piece of real estate we have a piece of real estate, and let's say let's talk about a capital event first. So capital event is when the property
sells. Yay, capital event. All right, so capital event occurs. So money comes down. And it hits this pool, right? So there's a big pool of money here. pool money pool. Alright, so there's big money pool. And now out of this pool, first what has to happen? So before you give any money back to your investors,
the next step that happens is expenses. These are expenses that happened before so that we can end up with net profits at the end, and that those net funds, so expenses, I mean, the big one obviously would be something if it was real estate is to pay back the loans, oh, my goodness. The other one, the one that's matters most to you is payment of fees. To you, Manager. Now, important side, note the payment of fees, most of the time these fees portion is going to be treated
as income on your taxes. So keep that in mind when you're doing your tax planning. So this happens first, right, so we pay off those, we pay out all the expenses, the loan, the whatever there is left, sometimes there's taxes, I've got other videos on that. But most of the time, it's you know, you got to pay your loans, you got to pay your fees, whatever else is owing, which ends you up at the end of the day with your net proceeds. So you've got your net proceeds that's supposed to look like $
sign, there you go. So you end up with your net proceeds now from the net proceeds. This is where we really start thinking about waterfalls. The most common first step out of the out of a waterfall is a return of capital. This goes to your investors. Right so that that money goes to your investors,
it's returning the amount of money that they have. So you're probably paying out all those Class A units, that amount of their initial capital contribution 99% of the time, this is what what is in the operating agreement and the PPM and it's described accordingly. So after Return of the capital, what happens next? So a lot of times there'll be a step here, that is the preferred return. So the preferred return let's say
it's 6%. That goes to the investors. Okay, this return of capital here as long as it is a return of capital to your investors is not taxed as long as it's not at tax to the point of which is this their basis, of course, cost segregation, other things like that can adjust that but I just giving you that brief like idea just so that you know. So your preferred return is coming to
your investors. Now the preferred return probably is taxed, and it would be taxed as long as you've held the asset for more than one The year it's going to be taxed your investors as a capital gain after the payment of the preferred return, sometimes and this isn't very common, especially in a real estate deal, but it certainly does happen and maybe 20 to 30% of the of the formations that are right the structures that
are right. And that is what's called a catch up. And that catch up will be normally it will be to the whatever that percentage is of the preferred return. And this gets paid to manager. So that catch up to the manager is a amount of money that is to bring them to this 6%. So what you're basically saying is, okay, investor, here's all your money back, I'm also going to give you a preferred return, which means I'm going to make sure that you get 6% of your money back before
anybody else gets any money. And so we give you 6% of the money back. But what that actually has done is it's decreased the size of this pool here. It's decreased that size of the pool such that now it's not in line with whatever buddy wouldn't necessarily think it is. So you can do the preferred return as a pure catch up of 6%, to the manager to make everybody fair,
but that alone would essentially be a 50/50 split, right? So that first 12% of profits would basically be okay, we're going to split that 12% 50/51, we're going to pay the investor, then we're going to pay the manager. But that's probably not what your investors are normally thinking that a catch up should be. Because if you're doing, for example, an 80/20 split, maybe it should be something different. Let's use a different, different math here so that I don't have to do the
math. But let's say we do a catch up, up to an additional say, say we're doing a split of 75. So that would be to the manager, we do a catch up of hey, manager, we're gonna catch you up a little bit because you didn't get to participate in that first 6%. And so we're gonna give it make sure that you get some profits, as you would expect from that next pool.
After this now we're in splitsville. So here, we might say something like, okay, split, we're gonna give 80% Actually, since we were doing 75, let's do, we're gonna give 75% to the investor. And we're gonna give 25% to the manager. After, let's say that we want to do a more complex waterfall than then would be normal. So we're going to say, we're going to split that pool of money, but we're not going to split all that money, we're going to say, let's split the profits that way for
just the next up to 20% of profit. And then after that, we're going to say, we're going to split the remaining profit 5050. And that's it. Right? So let's put some actual numbers to it. I think that might be useful as well. So let's say at the end of the day, our net proceeds equals $5 million. Right? And for that 5 million, let's say our investors invested two and a half million, so two and a half million goes into this category, right? So that leaves us with an additional now we've got here
we'll write it here. So now we've got 2.5 million left to divide. Right. Okay, so now we've got to make a division of other preferred return. Typically, you'll do that preferred return of 6% on the amount that they invested, which works out fine here. So the next 150,000 goes to your investors, which leaves us with 2 million 350. Right. Now we've got this catch up piece here. And so that is equal to just an additional 35.25k. That leaves us with With 2,000,003 852 50. Okay, so now
we're going to divide that pool up, just up to 20%. And because of my math, it's much easier to do this in Excel. I'm not going to do that here. And let's just say, we're going to do this simple waterfall here, because you'll get the point. So, so we've got that admission additional to $2,385,250. So of that, now, we give to the investor we're giving 1,000,007 88 937. And the remaining there we go. The manager gets
$596,313. Not bad, right? So the manager on this deal alone, just from the capital transaction is made that 596313 plus the 35 to 50. Plus plus whatever amount that they made to in the in the fees, which means that outside of fees, they've made a good $631,000 So this is the way that a that a waterfall works. Now if my name is Tilden Moschetti, I am a syndication attorney with
the Moschetti syndication Law Group. If we can help you put a syndication or fund together, we'd be happy to talk about it. We work exclusively under Regulation D Rule 506b or Rule 506c. That's what we do every day and make sure we can help you be successful.