This is the first in a series of detailed articles aimed to help you navigate the often complex terminology found in term sheets provided by venture capital (VC) funds. Our examples draw from language commonly found in documents issued by the National Venture Capital Association (NVCA), a reputable organization in the world of venture capitalism. For more about the NVCA, check out their official website where they provide a wealth of resources for entrepreneurs and investors alike.
In this article, we turn our attention to ‘Dividends’, an essential term for anyone involved in the business world.
Dividends, simply put, refer to the portion of a company’s earnings that is distributed to its shareholders. This distribution usually takes the form of cash or additional stock, allocated on a per-share basis. The board of directors of the company decides when and if dividends will be declared. It’s important to note, as per the corporate law of most states, including Delaware, companies are prohibited from declaring dividends unless they meet certain minimum financial criteria. These financial regulations are in place to ensure that companies can fulfill their financial obligations to third parties post-dividend declaration.
Venture-backed companies, however, are not generally prone to declaring dividends. But when they do, it’s crucial to understand the two primary types of dividends – non-cumulative and cumulative dividends.
Non-Cumulative Dividends:
Shareholders do not have an automatic right to dividends and companies can declare different dividends for different stock classes. In the context of venture capitalism, non-cumulative dividend provisions mandate that if a dividend is declared, both the preferred and common stock must receive the dividend. This essentially ensures that the company cannot distribute cash to common stockholders without also providing returns to investors.
The NVCA’s model language for non-cumulative dividends reflects this concept, as illustrated in the following examples: “Dividends will be paid on the Series A Preferred on an as-converted basis when, as, and if paid on the Common Stock,” and “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”.
Cumulative Dividends:
Unlike their non-cumulative counterparts, cumulative dividends accrue a set dividend amount annually regardless of whether the company declares dividends. Preferred stockholders are entitled to receive the accrued amounts when a dividend is declared, in addition to their share in the declared amount.
For instance, consider a simple cumulative dividend with a rate of 5% per fiscal year on preferred stock. If no dividends are declared, a share of preferred stock issued at $1.00 would accrue a dividend of $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 forth. There are variations to this model, including cumulative-compounding dividends, akin to compound interest rates, and cumulative dividends payable upon declaration or sale of the company, even if no dividend is otherwise declared.
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.”
Understanding the ins and outs of dividends, particularly in the realm of venture capital funding, is of utmost importance for entrepreneurs. Dividends can have a significant impact on your company’s financial health, future earnings, and overall growth strategy. They directly affect your investors, whose support and funding are vital to your company’s success. As such, having a solid understanding of dividends, both cumulative and non-cumulative, allows entrepreneurs to have informed discussions with their investors, maintain transparency about the company’s financial status, and plan the company’s financial strategies effectively.
Moreover, knowledge of dividends is crucial when negotiating venture capital term sheets. These documents can often be dense and filled with jargon, making them challenging for those not well-versed in venture capital terminology. Understanding these terms, however, is necessary to ensure that you are making the best decisions for your company and not agreeing to terms that might not align with your company’s best interests.
The world of venture capitalism can be complex and, at times, even overwhelming. It’s always advisable to seek legal counsel before making decisions that could potentially impact your company’s future. If you have questions about dividends, term sheets, or any other aspect of venture capital, a Montague Law attorney would be an excellent resource. Our team of experienced lawyers is well-versed in venture capital law and can provide invaluable advice tailored to your specific situation. With the right guidance and advice, you can ensure you’re making the best possible decisions for your company’s future. For more information or to schedule a consultation, visit the Montague Law website.
In Conclusion:
Understanding the concept of dividends is crucial for entrepreneurs and founders when it comes to negotiating a VC term sheet. Cumulative dividends can potentially impact a company’s valuation negatively as they represent an additional claim on future earnings. However, in challenging funding environments, where investors may have more leverage, they might push for cumulative dividends as a means to mitigate risk. Therefore, the comprehension of dividend provisions becomes critical while negotiating the structure of a deal.
