Waterfall Payment Explained: Its Function, Advantages, Operation, and Illustration
A waterfall payment structure, akin to a cascading waterfall filling up buckets sequentially, dictates how a debtor distributes available funds to creditors based on a predetermined order of priority. This structure prioritizes paying off the most senior or expensive loans first, minimizing insolvency risk and freeing up cash for other necessary expenses.
Understanding a Waterfall Payment
Imagine a waterfall, with various buckets strategically placed to catch the water as it flows down. Each bucket represents a different creditor, with the highest-tiered creditor (the first bucket) getting filled first, and only then does the water flow to the next bucket below. A waterfall payment structure operates similarly, ensuring higher-tiered creditors are paid principal and interest ahead of lower-tiered creditors.
Essential Waterfall Payment Details
- Higher-tiered creditors receive priority, meaning they are paid principal and interest before lower-tiered creditors get any payments.
- Lower-tiered creditors initially receive interest-only payments, as their debts are deferred in favor of higher-priority loans.
- A waterfall payment can either focus on paying off one loan at a time or systematically paying all loans.
How a Waterfall Payment Works in Practice
Suppose a company with multiple loans has different interest rates for each loan. Adhering to a waterfall structure, the company would make principal and interest payments on the costliest loan while making only interest payments on the remaining loans. Once the most expensive loan is paid off, it can then address the next most expensive loan by making all interest and principal payments. This process continues until all loans are repaid.
A Case Study: Creditor Payments
Let's say a company borrows money from three creditors - Creditor A, B, and C, in that order of priority. The arrangement would look like this:
- Creditor A is owed a total of $15 million over both principal and interest.
- Creditor B is owed $10 million in principal and $5 million in interest.
- Creditor C is owed $5 million in principal and $2 million in interest.
Assume the company earns $30 million in a year. It would first pay the entire $15 million owed to Creditor A, leaving it with $15 million in remaining funds. Subsequently, it would apply the remaining balance to Creditor B, ensuring both the interest and principal are fully paid. The company would then proceed to pay off Creditor C with the remaining funds.
This case study demonstrates the workings of a waterfall payment structure, prioritizing debt repayment based on the order of loan priority while ensuring that higher-ranking creditors are paid before lower-tiered creditors.
- In a waterfall payment structure, akin to a cascading waterfall, higher-tiered creditors are prioritized, receiving both principal and interest payments before lower-tiered creditors begin receiving any payments.
- A tenant or investor in the field of decentralized finance (DeFi) might find the waterfall payment structure appealing, as it ensures that more senior loans are paid off first, minimizing risk and freeing up resources for future investments.
- A start-up raising funds through various rounds of Initial Coin Offerings (ICOs) might benefit from a waterfall payment structure, as it allows them to allocate resources efficiently, prioritizing the repayment of expensive debts while deferring lower-priority loans.
