This article is one in a series of articles explaining various terms commonly seen in term sheets issued by venture capital funds. We give example language based on the commonly referenced National Venture Capital Association (NVCA) documents.
What Are Dividends?
A dividend is a distribution of a company's profits or excess earnings to its shareholders, typically in the form of cash or stock distributed on a per share basis. Dividends can be declared by the company's board of directors, however, most states, including Delaware, prohibit companies from paying out dividends unless the company meets certain minimum financial requirements to ensure that the company will be able to meet its financial obligations to third parties after a dividend is paid out.
While declaring dividends is an uncommon event in the venture world, there are two main categories of dividends to be aware of: non-cumulative and cumulative dividends.
Non-cumulative Dividends
As background, shareholders are not entitled to receive dividends and companies can declare different dividends on different classes of stock. Non-cumulative dividend provisions in the venture context provide that if a dividend is declared, the preferred must receive the dividend alongside the common stock. In short, a non-cumulative dividend provision is intended to prevent the company from giving cash to common holders without returning anything to investors.
The NVCA term sheet model language for non-cumulative dividends is either: "Dividends will be paid on the Series A Preferred on an as-converted basis when, as, and if paid on the Common Stock," which provides that if any dividends are declared, they will be paid equally on the preferred and common stock on a pari passu basis; or "Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board of Directors," which does not require dividends to be declared, but provides that if they are declared, a certain minimum amount must first be paid out to preferred holders before any other dividends are declared and paid to all stockholders equally.
Cumulative Dividends
In contrast, cumulative dividend provisions provide that shares of preferred stock will be entitled to accrue a set dividend amount per year even if the company does not in fact declare dividends. If the company does eventually declare a dividend, then the holders of preferred stock are entitled to receive any accrued amounts in addition to sharing in the declared amount. For an example of the most common and simple variant of a cumulative dividend, with a 5% cumulative dividend per fiscal year on the preferred stock, assuming no dividends are in fact declared, then the accrued dividend for a share of preferred stock with an issue price of $1.00 would be $0.05/share at the end of the first year, $0.10 at the end of the second year, $0.15 at the end of the third year, and so on (in addition to any other dividends if and when declared). Variations on cumulative dividends include (1) cumulative-compounding dividends (think, compound interest rates), and (2) cumulative dividends which are due both when declared and/or if the company is sold, even if a dividend is not otherwise declared.
It is important to keep in mind that venture investors are not usually aiming to receive regular interest payments from their portfolio companies since they generally prefer their companies use their cash to grow and scale. Therefore, if a company has to give cumulative dividends to their investors, it is worth making very clear in the term sheet that cumulative dividends will only be paid out if declared by the board or, failing that, if declared by the board and/or upon the sale of the company. Venture backed companies should not be compelled to make annual dividends, and it is not typical for dividends to be triggered by other events in the company's lifecycle such as upon an IPO or conversion into common stock.
The NVCA term sheet model language for cumulative dividends is: "The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption]. For any other dividends or distributions, participation with Common Stock on an as-converted basis."
Conclusion
It is very important for founders and entrepreneurs to understand the concept of dividends, especially when negotiating a venture capital term sheet. Cumulative dividends can potentially lower a company's valuation as they are an additional claim on the company's future earnings. However, in challenging funding environments or other scenarios where investors have relatively more leverage, investors are more likely to push for cumulative dividends as a risk mitigation tool, so it will be critical for founders to understand dividend provisions as they negotiate the overall deal structure.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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