God, this thread has attracted a few some sexist idiots who are stuck in the dark ages!
My preference is for everyone to have two surnames so that no-one changes their name after marriage and children share one surname with each parent (similar to the Spanish way).
However, I understand that two surnames aren't the norm in this country, many people prefer to just have one, and some surnames just don't work together. And I agree, OP, that your surnames don't work together. So in your case if you want to all share a name I think amalgamating them is a great solution.
Waterman is definitely the best option. FWIW I think Waterhouse is a great name and Smallman is terrible! But Waterman is quite cool.
If you'll permit a bit of unsolicited advice: tell as many people as possible about your surname plans before the wedding. Tell the person who will be announcing your arrival at the reception to announce you as "Mr and Mrs Waterman". Then send out the thank you cards with your names clearly written in the cards and on the envelopes.
Some people will still assume and get it wrong, but not nearly as many if you make a point of letting people know.