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What’s in a Term Sheet: Understanding Waterfalls

What do the Niagara River, 1990s R&B sensation TLC, and litigation finance term sheets all have in common?

Each involves waterfalls—though some more famous than others.

In this blog post, we’ll talk about the litigation finance version of waterfalls—what they do, how to read them, when they matter, and when they don’t.

First, some context

Waterfall provisions are not unique to litigation finance. They are common features of many investments, and they tell you how distributions are made to multiple parties to a transaction.

Imagine, for example, you take out a second lien on your home. Frequently, the waterfall provision requires that the “first” or “senior” lien holder must be paid back in whole or in part before the second lien holder can receive payments.

Or think about a venture-backed company that has raised multiple rounds of financing. Typically, different investors have different “priority” repayment rights. For example, a senior investor may be entitled to its principal and a return before junior investors recover.

Waterfall provisions operate in a similar way for litigation finance transactions. Case proceeds are usually divided among three parties: the claimant, the law firm, and the litigation funder. The waterfall tells you the order in which case proceeds are distributed to those three parties. A funding term sheet should clearly explain the waterfall.

How it works

Let’s talk about waterfalls by using an example. Imagine a term sheet with the following features:

Investment Amount

FeesCostsTotal
Funder$1,000,000$1,000,000$2,000,000
Law firm$1,000,000 in attorney time$0$1,000,000
Claimholder$0$100,000$100,000

 

Return Structure

Share of Case Proceeds
Funder20%
Law firm20%
Claimholder60%

 

The return structure is usually subject to the waterfall, which tells you the order in which proceeds are paid out. Usually, the funder and counsel—who typically make the biggest financial investment in the case—recover their investment amount, and frequently a return, before the claimholder recovers a significant share of proceeds. The claimholder then “catches up” by collecting a greater share of proceeds at later stages of the waterfall.

For example, the first step of the waterfall may provide that the funder receives 100% of case proceeds until it recover its deployed amount, or the amount of money it actually invested in the case. Thus, if the funder in our example invested $2 million in the case, the first $2 million in case proceeds would ordinarily go to the funder. Note that this provision operates as a catch-up for the funder, since the claimant usually has not invested nearly as much in the case, and the law firm has usually been paid at least 50% of its hourly rates.

Once the funder recovers its deployed amount, there is much greater variety in the later steps of the waterfall. For example, the waterfall may provide that the funder and law firm each recover some multiple of their invested amount before the claimholder begins to catch up. Thus if the waterfall provides that the funder and law firm receive a 2x return before the claimholder recovers, the waterfall would allocate $4 million to the funder (twice the $2 million they invested) and $2 million to the law firm (twice the $1 million in attorney time they invested) before the claimholder “catches up” in the waterfall. Exactly what the waterfall looks like usually depends on the case’s risk profile.

Don’t go chasing waterfalls

The waterfall is an important part of the term sheet, and where two funders are offering similar return structures, the waterfall provisions may make one funder’s term sheet more attractive.

But it is important to remember that, very often, the waterfall does not actually matter. The waterfall usually matters only when the case resolves below everyone’s expectations, such that all the case proceeds may be distributed before you make it through all the steps of the waterfall.

Imagine, for example, that our sample case resolves for $30 million. If the funder and claimholder are entitled to a 2x priority return before the claimholder is entitled to “catch up,” this means the first $6 million in case proceeds are distributed $4 million to the funder and $2 million to the law firm.

But because the case resolved for much more than $6 million, there are more than enough proceeds left over for the claimholder to fully catch up and receive its full targeted return of 60% of case proceeds, which in this case amounts to $18 million. The funder and law firm would receive no more than $6 million each (20% of case proceeds each)—which means that although they recover more money at earlier steps of the waterfall, the claimholder recovers the lion’s share at later steps.