What is the Waterfall Model in VC and How Does It Help?

n venture capital, the waterfall model is a game-changer. It’s not just a framework for splitting profits—it’s the blueprint for managing risk, reward, and investor relationships. Whether you're a seasoned general partner (GP) or a limited partner (LP) evaluating a fund, understanding the waterfall model is critical to protecting your interests and maximizing returns.

But what exactly is the waterfall model, and why does it matter? Let’s break it down step by step.

Stages of the Waterfall Model

The waterfall model operates in stages and each level ensures fairness and clarity in how profits flow. Here’s how it typically works:

1. Return of Capital

This is the “first stop” in the waterfall. LPs get their initial investment back before anyone else – no profits, no carried interest, just a full refund of the money they’ve contributed.

For example, imagine you invest $5 million into a fund. Before the GPs even consider touching profits, that $5 million comes back to you first. This stage is crucial because it reassures LPs that their capital is safeguarded.

2. Preferred Return (Hurdle Rate)

After the capital is returned, the next priority is the preferred return—essentially a minimum return guaranteed to LPs before the GPs receive their share. It’s usually set at 6–8%, compensating LPs for the opportunity cost of their investment.

Let’s say your fund has a 7% hurdle rate. On a $5 million investment, you’d receive $350,000 annually before the GPs start earning their share of the profits. This stage often sets the tone for LP-GP relationships: it shows how much the fund values its investors.

3. GP Catch-Up

This is where GPs begin to earn. The GP catch-up stage allows them to “catch up” on the profit distribution, aligning with their agreed-upon share (often 20%). It’s like hitting the gas pedal for fund managers—they’re now rewarded for getting LPs past their preferred return.

For example, if the fund generates $1 million in profits after the preferred return, GPs might take $200,000 to reach the 80/20 split agreed upon. This stage incentivizes fund managers to deliver strong results, as their earnings depend on exceeding LP thresholds.

4. Carried Interest

Finally, the remaining profits are divided according to the agreed profit-sharing split—usually 80% to LPs and 20% to GPs. This stage rewards the fund managers for their performance and motivates them to aim high.

If a fund generates $10 million in total profits, $8 million might flow to LPs while $2 million goes to GPs. This division reflects the collaborative spirit of venture capital: everyone wins when the fund succeeds.

Types of Waterfall Models

                                                                                              Image via Adventures in CRE

Not all waterfall models are created equal. There are two primary types: the European Waterfall and the American Waterfall. Let’s compare:

European Waterfall

The European model prioritizes LPs by requiring them to recoup their entire initial investment across the fund before GPs see a dime of carried interest.

‍Pros:

• Offers LPs significant protection.
• Ensures fund-wide success before GPs benefit.

Cons: Delays payouts for GPs, which may demotivate fund managers.

For example, if a $100 million fund uses a European model, all $100 million must be returned to LPs before GPs can earn carried interest. This approach ensures that LPs are fully covered for their capital outlays before profit-sharing begins. This model is common in private equity, where long-term, stable returns are often prioritized, and it’s increasingly popular among institutional investors in VC who value downside protection.

However, GPs operating under this model may face cash flow challenges, especially if the fund has long time horizons or delayed exits. This structure demands patience and confidence from fund managers, as their earnings hinge on comprehensive portfolio performance rather than isolated successes.

American Waterfall

In contrast, the American model distributes profits deal by deal. GPs can earn carried interest after a single successful exit, even if the overall fund hasn’t yet recouped LP investments.

Pros:

• Faster payouts for GPs.
• Encourages aggressive, early-stage deal-making.

Cons: Riskier for LPs, as losses from unsuccessful deals may offset gains from profitable ones.

For example, imagine a VC fund that generates a $10 million profit from one startup. With the American model, the GP could immediately take $2 million (20%) in carried interest—even if other deals in the portfolio end up failing. This approach enables GPs to realize quicker returns, providing strong incentives for high-stakes investments and early exits.

While this model is GP-friendly, LPs might feel the pinch if a portfolio has uneven performance. Profits from one deal may not fully cover losses from another, leaving LPs with subpar net returns. As a result, some LPs view the American model as more speculative compared to the European approach.

Which Model is Right for You?

It depends on priorities:

Limited Partners: The European model is a better fit if you prioritize security and consistent returns. It appeals to investors focused on minimizing risk and ensuring portfolio-wide accountability.

General Partners:  The American model is the way to go if you want quicker rewards and more flexibility. For fund managers focused on shorter timelines and opportunistic investing, this structure can be highly appealing.

Some funds adopt hybrid models, combining elements of both—for instance, using deal-by-deal distributions after meeting a fund-wide hurdle rate. These hybrids balance the need for GPs to receive timely incentives while maintaining a level of security for LPs. Other variations may include clawback provisions or performance-based milestones to address the unique dynamics between stakeholders.

How Waterfall Models Impact LP-GP Relationships

The waterfall model is more than just a math problem—it’s a trust exercise. The structure you choose can shape the dynamics of LP-GP relationships for years.

Transparency Is Key

LPs want to know exactly how and when profits will be distributed. A poorly explained waterfall structure can lead to friction and even litigation. On the flip side, clear, well-communicated terms build trust and confidence.

Aligning Incentives

The best waterfall models balance risk and reward. GPs should feel incentivized to maximize returns, while LPs should feel protected from undue risks. Misaligned incentives can create resentment—especially if LPs feel shortchanged by aggressive GP payouts.

Negotiation Tips

• For LPs: Push for European waterfalls to prioritize your capital. If the GP insists on an American model, ask for clawback provisions to protect against future losses.
• For GPs: Advocate for deal-by-deal payouts but be prepared to offer compromises, such as a lower hurdle rate or hybrid structures.
• Compromise: Consider a tiered structure that adjusts carried interest percentages based on fund performance—rewarding success without compromising trust.

Waterfall Model Real-World Examples

Sequoia Capital

Sequoia’s global growth fund uses a hybrid waterfall model, blending fund-wide thresholds with deal-specific payouts. This structure has helped them build lasting LP relationships while keeping GPs motivated.

Andreessen Horowitz

In its early funds, Andreessen Horowitz favored the American model, allowing GPs to cash in on big early exits like Instagram. However, feedback from LPs led to the inclusion of clawback provisions in subsequent funds, creating a better balance.

Clean Energy VC Fund

A new $200 million fund focused on renewable energy adopted a European waterfall. While GPs faced delayed payouts, the structure reassured institutional LPs, leading to increased commitments for future funds.

How the Right Waterfall Model Drives VC Success

In the world of venture capital, it’s not just about how much you earn.

It’s about how you earn it.

The waterfall model isn’t just about splitting profits—it’s about setting the stage for success. By choosing the right structure and negotiating terms that work for both LPs and GPs, venture capitalists can create a win-win scenario.

Whether you prefer the security of the European model or the flexibility of the American model, the key is clarity. A well-defined waterfall builds trust, aligns incentives, and ensures everyone benefits when the fund succeeds.