This post is the third in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior two posts, we provided an introduction to the negotiation of a venture capital term sheet, discussed binding and non-binding provisions, and discussed valuation, cap tables, and price per share. This post will focus on dividends on the preferred stock issued in a venture deal.
Dividends are one of the rights that often make preferred stock “preferred” (relative to common). In short, dividends increase the total return to the preferred stockholders and decrease the total return to the common stockholders. Dividends are often stated as a percentage of the original issue price for the preferred stock (e.g. a dividend may be stated as 5.0% of the “Series A Original Issue Price”; the original issue price is simply the price paid for the stock by the preferred investors). There are at least three common ways dividends are structured in venture capital deals, which are as follows:
- Cumulative dividends
- Non-cumulative dividends
- Dividends on preferred stock only when paid on the common stock
Cumulative dividends are the most beneficial to the preferred stock and the most burdensome on the common. Cumulative dividends accrue on the original issue price and are typically paid on liquidation of the startup or upon redemption of the preferred stock (most startups do not have funds to pay dividends currently, so that’s the reason for payment upon liquidation or redemption). The accruing dividends represent a future obligation of the startup to the preferred stockholders which reduces funds available for common stockholders. Cumulative dividends may be structured on a simple basis, where the accruing dividend is calculated on the original issue price but not on any previously accrued and unpaid dividends, or on a compound basis, where all prior accrued and unpaid dividends are taken into account in determining future dividends (the same concept as simple versus compound interest).
Non-cumulative dividends, on the other hand, are paid on the preferred stock only if the Board of Directors declares them; if they are not paid, they do not accrue and do not result in a future obligation to the preferred stockholders. So you may have an 8.0% dividend preference for the preferred stock; however, if the Board of Directors does not declare the dividend, then it’s forfeited. This is a significantly better structure for the common stockholders.
The third common method of structuring dividends in a venture deal is to have a dividend paid on the preferred only if paid on the common. In this scenario, the preferred is treated as if it had been converted into common at the time the dividend is declared and the preferred and common stock share in the dividend as if all shares were converted to common. This is the least beneficial to the preferred stock (this structure does not result in a dividend preference to the preferred stock at all) and the most beneficial to the common stock.
For a sample term sheet containing these three options, see the National Venture Capital Association’s term sheet here.
For startups negotiating a venture deal, you should understand the various ways dividends can be structured and consider (i) the likelihood that cash flow will be available to pay dividends currently (as opposed to upon liquidation, for example) and (ii) the dividend structure’s impact on the total return to the preferred stockholders and the diminution in total return to the common stockholders. Cumulative dividends can particularly affect the returns if the holding period is relatively long (and this is even more true if the unpaid dividends are compounded).
In the next post, we’ll discuss another item that makes the preferred stock “preferred,” which is the liquidation provisions.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
