What is a Preferred Return?

Preferred return is a specific term you will see in term sheets and operating agreements. It refers to a claim on profits.

Specifically, it is a preferential rate of return on capital that must be paid to investors before the general partners or founders receive any share of the profits.

In the world of private equity and venture capital, this is often called the hurdle rate.

It acts as a threshold. Until the business generates enough cash to pay back the original capital plus this specific percentage return, the people running the business usually do not participate in the profit split known as carried interest.

Imagine an investor puts one million dollars into your company. They negotiate an eight percent preferred return.

This does not mean you write them a check for eight percent every year like a loan payment. Instead, it dictates the order of payout when a liquidity event happens or when dividends are distributed.

The waterfall generally looks like this:

• First, 100 percent of cash goes to the investor until they have their one million dollars back.
• Next, 100 percent of cash continues to go to the investor until they have received that eight percent return calculated annually.
• Only after those two buckets are full do the founders or general partners start receiving their share of the remaining profits.

It is easy to confuse preferred return with interest on a loan, but there is a distinct difference.

Interest is a liability. You must pay it regardless of how the business performs. If you miss a payment, you are in default.

Preferred return is a function of equity. It is a priority claim on available profits. If there are no profits to distribute, the preferred return usually keeps accruing, but it does not trigger a bankruptcy the way a defaulted loan would.

However, the accrual feature brings up a question you need to ask during negotiation. Is the return cumulative or non-cumulative?

If it is cumulative, every year you do not pay it, the amount owed grows. If it compounds, you end up paying a return on the unpaid return. That can get expensive quickly.

There is often a mechanism paired with preferred returns called a catch-up.

Once the investor gets their capital and their preferred return, the deal might switch to a GP catch-up. This allows the founders to receive 100 percent of the next chunk of cash until their total payout equals their agreed upon profit split percentage of the total profits.

After the catch-up is met, the remaining money is split at the final pro-rata rate.

This structure is designed to protect the investor. It ensures that if the business only does okay, the money goes to the capital providers first.

For a founder, this raises important questions.

Does your business model support high enough margins to clear this hurdle?

Are you accepting a hurdle rate that is realistic for your industry?

If the preferred return is too high, you might be building a company where you do all the work but never see the upside.