Rights & Preferences: What You Need to Know About Dividends

These are not usually a real point of negotiation with venture capital term sheets but we have seen terms that can be dilutive to founders and its best to understand what these terms mean and how they affect you and your company.

First I want to take a moment to discuss what a dividend is and a little background on it. I know this is basic to some but much written about dividends as it pertains to VC assumes you know what they are, maybe you do, but for those that don’t or at least for those that have the humility to admit you don’t, let’s get started.

What is a Dividend?

A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Typically dividends are issued as cash payments or as shares of stock.

A company’s net profits can be allocated to shareholders via a dividend, or kept within the company as retained earnings. A public company may also choose to use net profits to repurchase their own shares in the open markets in a share buyback. Dividends and share buy-backs do not change the fundamental value of a company’s shares. Dividend payments must be approved by the shareholders and may be structured as a one-time special dividend, or as an ongoing cash flow to owners and investors.

What Kind of Companies Issue Dividends?

Start-ups and other high-growth companies such as those in the technology or biotechnology sectors rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth and expansion.

Companies in the following sectors and industries have among the highest historical dividend yields: basic materials, oil and gas, banks and financial, healthcare and pharmaceuticals, utilities, and REITS.

Why do Companies Issue Dividends?

The argument for dividend policy claims that investors are less certain of receiving future growth and capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividend payments. The main argument is that investors place a higher value on a dollar of current dividends that they are certain to receive than on a dollar of expected capital gains, even if they are theoretically equivalent. Ok, much of this is not relevant as you will not have positive retained earnings if you follow the typical VC backed growth model.

How Dividend Policy Can Affect Startups

Cumulative dividends:

Cumulative dividends can act as a protective provision for investors to provide a minimum annual rate of return and it is thus tied-into the liquidation preference. In my experience this is not as common however many other blog posts have posited that the number of financing rounds with this feature is around 7-10 percent. I have not seen a supportable or even cited source for this number. In my experience I have seen this feature in two situations. One, the company may not have performed well relative to its projected plan on the previous financing round or there have been other internal challenges the company has faced and the investor is concerned or looking to mitigate risk on the most recent round. Second, I’m going off my experience here and do not necessarily have any data to support this ( I will try to see if I can pull it and post later) but I have seen this often outside of traditional “startup hubs” where maybe the terms on deals are not that well known or as standard.

If you are going to agree to cumulative dividends I would 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) or upon the conversion of preferred stock into common stock (because the protection is not needed in such cases).

When and If is Most Favorable and Typical:

The more common and favorable provision is when dividends are declared when and if declared by the BOD and comes in two variations. Typically reads 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.”