Why You Need to Take a Close Look at Dividend Provisions Most dividend provisions fall into one of three categories. Do you understand the differences between them?

In the last two installments of this series, I tried to deconstruct two important aspects of a venture capital term sheet, namely how to analyze the valuation proposed by an investor and the manner in which the liquidation preference provisions can affect valuation. There is one other economic term that deserves careful consideration: the dividend provision.

So what exactly is a dividend? A dividend is a payment or distribution by the corporation to its stockholders. But here's the catch: In over 20 years of practice in the venture capital space, having worked with hundreds and hundreds of venture-backed companies, I have never seen a private, venture-backed company pay a cash dividend to its stockholders.

Why? Because venture-backed companies deploy cash to grow and build their business and do not generate returns for investors from their cashflow. It's that simple.

So you might ask: If venture-backed companies don't pay cash dividends, why do I need to worry about dividend provisions? Well, here's the answer. Dividend provisions can be structured to create and build an internal rate of return on an investment that is realized upon redemption or an exit through a sale or an IPO.

Related: What Every Entrepreneur Should Know About Valuations

As a result, venture term sheets typically address the amount and manner in which dividends are to be paid. Most dividend provisions fall into one of three categories:

1. Dividends that are payable on the preferred stock when, as, and if paid on the common stock
2. Noncumulative dividends that are payable on the preferred stock, if and when declared by the board, in a prescribed amount (typically a percentage of the price per share in the range of 4 to 8 percent)
3. Cumulative dividends that accrue on the preferred stock in a prescribed amount, regardless of whether or not they are declared by the board.

The first example above is the "friendliest" version. It doesn't give the venture investors any special dividends. The second example above is the next friendliest since it conditions payment upon a specific dividend being declared by the board. And, given the fact that a board would be very unlikely to ever declare such a dividend, this provision is viewed as fairly benign. The last example above, however, ain't so friendly. That is the one that you'll need to think about, because it affects the economics of your deal.

Here's how. Let's say a venture investor is proposing an 8 percent dividend on $5 million. That means that the investment grows by $400,000 each year and in, say, five years, the liquidation preference for the $5 million investment will have grown to $7 million. And of course, given the general predilection of future investors not to want anything less than earlier investors, the dilutive effect of cumulative dividend provisions can add up as the company raises more venture capital to finance its growth.

Now here's the good news. Most venture capitalists, particularly early-stage investors, don't use dividend provisions to goose their returns. Remember that most venture capitalists are swinging for the fences with their investments. While dividend provisions may provide a measure of downside protection in bad or mediocre outcomes by generating a modest return, or may otherwise give later-stage investors who are targeting smaller multiples on their investment a built-in return, venture capitalists are "venturing" their money for big returns. And those are obtained by building big businesses. For those investors, the modest returns that can be gotten through cumulative dividends simply don't move the needle.

So, if you are faced with a term sheet that has cumulative dividends, you should pause and do the math to think about how it may move the needle for you.

Related: Everything You Wanted to Know About VC Liquidation Preference But Were Afraid to Ask