Demystifying the VC term sheet: Dividends

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

In response to my last two posts demystifying VC term sheets (specifically addressing exploding term sheets and no shop provisions and price-based anti-dilution provisions), I have received a number of questions regarding other terms and provisions in term sheets.

Accordingly, I thought it would be helpful to address each of the questions over the next several weeks –creating a comprehensive series of posts relating to VC term sheets.  Beyond the most recent topics, I have also previously addressed valuation, liquidation preferences and stock options.

Today, we’ll look at dividends and how to protect your company from over-reaching by the investors. Dividends are generally not a huge issue in connection with the negotiation of VC term sheets; however, founders need to watch-out for mandatory cumulative dividends, as well as stock dividends that could be extremely dilutive to them.

Let’s go over some of those terms.

What is a dividend? A dividend is, in essence, a distribution of the company’s profits to its shareholders, which is generally paid 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 until the right is terminated. In short, it accumulates (and sometimes investors require compounding).

Cumulative dividends as a protective device – Cumulative dividends are relatively rare (10 percent or less of financings have them). 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 (say, 7-10 percent) – 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 (such as the sale of the company) and will be 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]….”

Provision 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, payable only if and when declared by the Board, and prior and in preference to any declaration or payment of any other dividends.”

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.