How does the waterfall and preferred return work in a self-funded deal?

What is the order of payments?

Every dollar from a sale, refinancing or distribution follows the same order. Each tier is paid in full before the next receives anything.

1. Senior debt. The SBA loan and any other bank debt.
2. Seller note. If the seller note is on full standby, it receives no principal or interest for the life of the SBA loan, then comes due once the SBA loan is repaid.
3. Sale costs. Advisory, legal and other transaction expenses.
4. Liquidation preference. Investors receive their capital back, commonly 1.0x.
5. Preferred return. Investors receive the return that has accrued on their capital, commonly 8–12% a year.
6. Common equity. What remains is split by ownership. The searcher typically holds roughly 60–80%.

How does the preferred return accrue while the SBA loan is outstanding?

Usually without being paid. As of October 2026, SBA rules say that if minority-investor equity counts toward the 10% equity injection, those investors generally get only tax distributions until the SBA loan is repaid. On a loan with a 10-year amortization, the preferred return can accrue for a long time.

That makes two details matter.

• Simple or compounding. At 10% simple on $400,000, six years accrue $240,000. Compounding annually, the same six years accrue about $308,600.
• Capital or credit. If investors received a step-up, check whether the preferred return accrues on the cash they invested or on the stepped-up credit.

What is the difference between participating and non-participating preferred?

• Participating preferred takes its liquidation preference and preferred return first, then also shares in the remaining common by its ownership percentage. Investors are paid twice on the same capital.
• Non-participating preferred (sometimes called simple or straight preferred) takes the greater of two amounts: its preference plus preferred return, or its share of all the equity as if converted to common. It does not take both.

In a weak outcome, both versions protect investors. In a strong outcome, participating preferred keeps taking a share of the upside on top of the preference. That is where the searcher's cost shows up.

If you are a searcher or an investor

If you are a searcher, you pay for participation only in good outcomes. Before you accept it, ask whether a cap is possible: participation that stops once investors reach a set multiple. Or trade it for a lower preferred return.

If you are an investor, participation is how you reach the 30–40% IRR self-funded investors commonly target at moderate exit values. Without it, you need a larger exit to get there. Both sides should run the waterfall at several exit values, and have a lawyer review the operating agreement, before signing.

Worked waterfall: one deal, two exits, two structures

All amounts are assumptions. The rates sit inside the market ranges above.

1. Investors put in $400,000 and own 30% of the common. The searcher owns 70%.
2. Preferred return: 10% simple, accrued for six years: $240,000.
3. Investors' preference plus preferred return: $400,000 + $240,000 = $640,000.
4. Strong exit. Enterprise value $6,600,000, less $1,400,000 of remaining SBA debt and $200,000 of sale costs: $5,000,000 to equity.
5. Participating: investors take $640,000, then 30% of the remaining $4,360,000, which is $1,308,000. Investors total $1,948,000. Searcher $3,052,000.
6. Non-participating: investors take the greater of $640,000 or 30% of $5,000,000. That is $1,500,000. Searcher $3,500,000.
7. Difference: $448,000 moves to the searcher under non-participating terms. Investors earn about a 30% IRR participating and about 25% non-participating.
8. Weak exit. $800,000 to equity.
9. Participating: investors take $640,000 plus 30% of $160,000, which is $48,000. Investors total $688,000. Searcher $112,000.
10. Non-participating: investors take the greater of $640,000 or $240,000. Investors $640,000. Searcher $160,000.

The weak exit shows what the preference is for. The searcher owns 70% of the common but receives 14–20% of the proceeds. The strong exit shows what participation costs.

Where these numbers come from: The preferred return, liquidation preference, step-up, searcher ownership and investor IRR target come from Smash and Searchfunder. The tax-distribution rule, full-standby seller notes and 10-year amortization come from SOP 50 10 8.1 as summarized by Beancount and Cantrell Firm. SOP 50 10 8.1 applies to loans that receive an SBA loan number on or after October 1, 2026 (SBA Information Notice 5000-880695).

Related questions

Does the searcher's salary come before the waterfall?

Yes. Salary is an operating expense, paid before profits exist to distribute. Self-funded searchers commonly take $100,000–$150,000. Investors watch it closely, because every dollar of salary above market is a dollar outside the waterfall.

Where does a seller's rollover equity sit in the waterfall?

Wherever the documents put it. Rollover can be common equity alongside the searcher, or the seller can negotiate preferred terms. Agree on it before the LOI becomes a purchase agreement.

Can the waterfall change after closing?

Only by amending the operating agreement, which usually needs investor consent. A new raise for a second acquisition is one reason to reopen it. Plan for that in the first agreement.

What happens to the waterfall if the company is never sold?

The preferred return keeps accruing. Investors are paid through distributions once the SBA loan allows them, or through a refinancing, a buyback or a listing. Write the liquidity path into the agreement.

What comes next

Independent sponsors use a different waterfall, built around fees, a hurdle and carried interest. That is covered in What are typical independent sponsor fees and carry?

Related articles

• What are standard investor terms for a self-funded search?
• How does an equity step-up work in a search deal?
• What are typical independent sponsor fees and carry?
• How much salary can I pay myself after buying a business with investors?
• How do you build a holding company for acquisitions?

Meraki Dealmakers is a service of Meraki Partners, LLC, an advisory firm. It is not a broker-dealer, investment adviser, business broker, law firm or accounting firm. This article is general information, not legal, tax or investment advice.