VC Term Sheets – Dividends

by Scott Edward Walker on March 3rd, 2011

Introduction

This post originally appeared as part of the “Ask the Attorney” series I am writing for VentureBeat.  Below is a longer, more comprehensive version, which is part of my series on venture capital term sheets.  Here are the issues I have addressed to date:

Today’s post relates to dividends and how to protect the company from over-reaching by the investors.

What Is a Dividend?

A dividend is, in essence, a distribution of the company’s profits to its shareholders, which is generally made in cash or stock.  Cash dividends are obviously rare in early-stage companies because there are usually no profits (or cash) to distribute; and, if there were, they would generally be re-invested in the growth of the company.  Stock dividends are problematic due to their dilutive effect.

There are two types of dividends: non-cumulative and cumulative.  With a non-cumulative dividend, if the Board of Directors does not declare a dividend during a particular fiscal year, the right to receive the dividend extinguishes for such year.  With a cumulative dividend, the dividend is calculated for each fiscal year and the right to receive the dividend is carried forward until it is paid or the right is terminated; in short, it accumulates (and sometimes investors also request compounding).

Cumulative Dividends as a Protective Device

Cumulative dividends are relatively uncommon (10% or less of financings); however, investors sometimes push for some form of cumulative dividend as a protective device to provide a minimum annual rate of return on their investment (e.g., 7-10%) – and it is thus tied-into the liquidation preference.  If the company capitulates on this issue, it must make clear in the term sheet that cumulative dividends will only be payable if there is a liquidation event (e.g., the sale of the company) and forfeited in the event of an IPO or upon the conversion of preferred stock into common stock (because the protection is not needed in such cases).

This provision would look like something like this in the term sheet: “The Preferred Stock will carry an annual __% cumulative dividend [compounded annually], payable solely upon a liquidation [or redemption]….

Provisions Most Favorable to the Company

A dividend provision most favorable to the company would look something like this: “Dividends will be paid on the Preferred Stock on an as-converted basis only if, when and as paid on the Common Stock.”

This is favorable to the company because the investors’ only right to a dividend is to participate with the common stockholders when and if declared by the Board.  Typically, however, investors will be given a limited preference to be paid first if a dividend is declared.  That provision would look something like this:

Annual [8%] non-cumulative dividends on the Preferred Stock will be payable only if and when declared by the Board, and prior and in preference to any declaration or payment of any other dividends.

Conclusion

Dividends are generally not a huge issue in connection with the negotiation of a VC term sheet; however, as discussed above, founders need to watch-out for mandatory cumulative dividends, as well as stock dividends that could be extremely dilutive to them.  Next week we’ll look at Board control.

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