Anatomy of a Term Sheet 3 – Dividends

Welcome to Part 3 of my series, Anatomy of a Term Sheet. If you are new to this series, I am analyzing in detail a Series A investment term sheet, using the model term sheet from the National Venture Capital Association.

Part 1 of the series, which addressed some basic introductory terms, can be found here. Part 2 dealt with pre-money valuation, and in particular, the dilutive effect of the option pool. It can be found here.

The next group of terms from the model Term Sheet deals with charter terms, or terms that will affect the startup company’s certificate of incorporation. The certificate of incorporation, or charter, will need to be amended to create a new class of stock, the preferred stock, which is what the Series A investors will purchase. There are quite a few terms relating to the rights of the Series A Preferred stockholders, and many of them are complex, so I will spread out the discussion over several installments of this series.

The first of the charter terms deals with dividends. Take the jump with me for a discussion of the three alternative dividend terms in the Term Sheet…

Alternative 1:  Dividends will be paid on the Series A Preferred on an as‑converted basis when, as, and if paid on the Common Stock 

The purpose of this first alternative is to ensure that the startup cannot pay out dividends to the common stockholders without also paying dividends to the Series A Preferred holders, treating them as if they have converted their stock to common stock. It is a fairly favorable term for the startup, because it doesn’t impose any specific requirement to pay dividends. It merely puts the preferred stockholders on an even footing with the common stockholders with respect to any dividends the business decides to pay.

Alternative 2The 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.

This alternative does several things. First, it specifies that the dividends for the Series A Preferred will be annual and cumulative, rather than at the pure discretion of the board of directors. That is, there will be a specific dividend amount each year, and the holders of the preferred stock have the right to receive accrued (previously unpaid) dividends in full before dividends are paid to any other class of stock. Second, these cumulative dividends must be paid upon a liquidation or redemption of the preferred stock. This alternative can be viewed as a means of providing a specified annual rate of return to the investors. Founders should push back and require that any such dividends only be payable upon a liquidity event (like the sale of the company), and that the dividends be forfeited in the case of an IPO or conversion of the preferred stock into common stock; the investors don’t need the protection of an annual cumulative dividend in those cases.

Alternative 3:  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.

This alternative specifies a dividend amount for the preferred stock, but the dividends are neither annual nor cumulative. The board can decide whether or not to pay dividends to the preferred stockholders, but the amount is set in advance.

In general, dividends are not going to be a big issue for startups. The main goal of these companies is to find a way to generate revenue and profits, and it may be years before the company is in a financial position to pay dividends. When startups do begin to generate cash, a higher priority is reinvesting in the company. Indeed, tech companies often delay years before paying dividends. Microsoft paid its first dividend in 2003, almost 30 years after its founding. Intel paid its first dividend in 1992, 24 years after it was founded. Google was founded in 1998 and has never paid a cash dividend.

Even though the payment of dividends is most likely going to be deferred for years, it is still important to understand how the dividend terms work, in particular the second alternative, which gives the board of directors the least amount of discretion with regard to paying dividends. None of the above alternatives provide for stock dividends, but that is something else that founders need to watch out for. Stock dividends have the effect of further diluting the founders’ holdings.

Next time: the liquidation preference terms.

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