Term Sheet Series — Post #4 — Dividends

By Luciana Jhon Urrunaga, Esq. and Anibal Manzano, Esq.

This is post #4 in our Term Sheet series for venture capital equity financings. Find our previous posts here.

A dividend is a distribution of profits by a company to its shareholders. Dividend rights are typically not a point of contention when negotiating startup term sheets because profits are rare in early-stage startups and, even assuming a startup was earning profits, that capital would be reinvested into the company to accelerate its growth. Still, it is important to understand the different types of dividend rights afforded to investors in connection with a financing and what these rights could entail for the company and its common shareholders in terms of future payouts and dilution. Although early-stage investors generally do not expect dividends, and actually prefer any profits or cash to be reinvested into the business, investors that are not accustomed to investing in early-stage startups may insist on them to mitigate the risk of their investment.

Dividends can be paid in cash or in stock. Dividend rights for preferred shareholders are typically structured in comparison to those of common stockholders. Generally, dividend rates range between 5% to 10% of the original issue price of the preferred stock, with less than 1% of financings having a dividend rate greater than 8%. The NVCAA term sheet, lists three alternatives for dividend rights: (i) cumulative dividends, (ii) non-cumulative dividends, and (iii) dividends paid on the same basis as those paid to common shareholders (on an as-converted basis).

I. Cumulative Dividends

With cumulative dividends, even if the board of directors decides not to issue a dividend for a certain fiscal year, the right of the preferred shareholder to receive that dividend accumulates year after year until a dividend is paid. Cumulative dividends can either accrue (i) on the original issue price but not on any previously accrued and unpaid dividends or (ii) on all prior accrued and unpaid dividends. This scenario is least beneficial to the common shareholders because the preferred shareholders must be paid in full before the common shareholders can receive any of their dividends. Cumulative dividends are extremely rare—less than 5% of financings include this term—and should be avoided whenever possible. If an investor requires cumulative dividends, the company should include the language making clear that the dividends are “payable upon a liquidation or redemption” of the company.

II. Non- Cumulative Dividends

With non-cumulative dividends, if the board of directors does not declare a dividend during a certain fiscal year, then the preferred shareholder forfeits the right to receive a dividend for that year. Dividends not paid in prior years do not accumulate to the next, a structure that is much friendlier to the common shareholders.

III. Dividends on par with Common Shareholders

The dividend provision that is most favorable to the common shareholders and the company would require dividends to be paid on the preferred stock only if they are also paid on the common stock. In essence, the preferred stock would be treated as if it had been converted into common at the time the dividend is declared.

About the EDITOR

Anibal Manzano is a corporate lawyer who specializes in venture capital and startup law, mergers and acquisitions, and cross-border transactions connected to the United States and Latin America. He is based in Boca Raton, Florida and regularly represents startups and investors in connection with venture capital financing transactions and related corporate and securities matters.

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