How a search fund distribution waterfall works, and where one-time cash goes

The short answer: the operating agreement sets the order

A search fund distribution waterfall is the payment order written into the acquisition company's operating agreement, or its charter and investor agreements if it is a corporation. Investors' preferred equity is usually repaid first, together with any accrued preferred return the documents provide. Only then does common equity share in what is left, split between investors and the units the CEO has vested.

Two things sit outside the equity waterfall but decide whether any cash reaches it. Lenders and the seller-note holder limit distributions through covenants, and the board decides whether to distribute at all. That is why a one-time payment, such as a fee for licensing the company's operational records, needs a written plan before the license is signed rather than after the money lands.

How does cash move through a search fund waterfall?

Cash moves down a stack, and each layer is paid only once the gate above it is cleared.

Structures differ more than people expect. Some search funds issue participating preferred, which takes its preference and then also shares in the common; others use convertible preferred, where investors take the greater of their preference or their as-converted share. Read the definitions before building a model, because terms such as distributable cash, capital contributions and unreturned capital carry the economics.

Why do the CEO's vesting tranches matter for a distribution?

A searcher's common equity typically vests in tranches: one at closing, one over time and one on performance, where the performance test is usually measured on investors' realized returns. Returning cash early can move investors closer to that test, depending on how the hurdle is written.

That raises a fair board question: should a one-time, non-operating payment count toward the performance hurdle, or be carved out because it does not reflect operating improvement? Either answer can be reasonable. The friction comes from finding the question after the cash arrives. Settle it in writing, and confirm whether unvested units share in distributions, have their share held back until vesting, or are excluded.

A short line from an investor-director to the CEO keeps the conversation clean:

Where should one-time license cash go?

There are four realistic uses. The right one depends on leverage, covenant headroom and what investors expect from the rest of the hold.

A simple decision rule is the three-gate test. The lender gate: is the payment permitted and free of sweeps? The document gate: what does the waterfall do with it, including vesting? The board gate: what did the board agree before the license was signed? If any gate is unclear, hold the cash in reserve until it is resolved.

How the payment is booked affects covenants and exit value

Accounting treatment matters because leverage covenants and exit valuations run on reported earnings. Under ASC 606, a license of intellectual property is assessed either as a right to use the IP as it exists when granted, recognized at a point in time, or as a right to access it over the license period, recognized over time. Deloitte's revenue recognition roadmap on the nature of a license sets out that analysis. How a particular data license is structured decides which applies, so bring the company's auditors in before the terms are final.

For valuation, expect a future buyer's quality-of-earnings work to treat the payment as non-recurring. Plan around a single payment, keep it out of run-rate EBITDA in board materials, and check whether your credit agreement's EBITDA definition includes or excludes it for covenant purposes. This is general information, not legal, tax or financial advice. Confirm with your own counsel, tax adviser or auditors before acting.

What this means for a search fund investor who refers a company

Search fund investors often back several searchers, sit on boards and see each company's systems during diligence, which makes them well placed to notice a company worth introducing. The fit test is narrow: a US company with 50+ full-time employees at peak (contractors excluded), several years of documented operations, clear rights to the records it would license and a sponsor such as the CEO who can sign. Smaller search acquisitions will not meet the headcount line; who qualifies lists the full baseline. The same screen scales across a larger book, as described in referral opportunities for private equity operating partners.

Your part is the introduction. The CEO takes it to the board, then the company works with SourceX on qualification, a data inventory, price and terms; you never export, upload or describe confidential records. A fractional CFO who already maintains the cap table can model the waterfall questions above; see fractional executives at search fund companies.

Partners earn 25% of the eligible platform fees SourceX actually collects from the referred company's licensing deals, capped at $100,000 per referred company. The reward is paid only after the buyer pays and SourceX receives its fee; an introduction, meeting or signed agreement alone does not trigger payment, and no reward is guaranteed. Because the reward comes out of SourceX's fee, it never reduces what the company, and therefore its waterfall, receives. Disclose it to the CEO and your co-investors before the board votes, and check your own fund's policies.

Limits and questions to settle before signing

A license changes the company's obligations, not only its cash. Licenses through SourceX are typically exclusive for AI training for an agreed term, and a future acquirer inherits that commitment, so it belongs in exit diligence. The company keeps ownership of its records; it grants rights to use them and signs only when price and terms work.

Before the board approves, get answers to these:

1. Does any credit agreement clause claim this payment as a mandatory prepayment?
2. Will lenders count it in EBITDA for covenant tests, or exclude it as non-recurring?
3. Does it count toward the CEO's performance hurdle?
4. Do unvested units share in a distribution, or is their share held back?
5. Who records the use-of-proceeds decision, and in which board minutes?

Deal-by-deal investors face a similar approval chain, covered in what is a pledge fund.

Next step

If a company in your search portfolio clears the baseline, register as a partner and introduce the CEO, or have the CEO apply at sourcex.si/apply with your referral link. Investors meeting new searchers at the 2026 search fund and ETA conferences can use the network opportunity finder to decide which relationships to raise it with first.