You can be on Entrepreneur’s cover!

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?

By Bo Yaghmaie

entrepreneur daily

Opinions expressed by Entrepreneur contributors are their own.

Shutterstock

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

Bo Yaghmaie

Head of New York Business & Finance Group, Cooley LLP

Bo Yaghmaie is the head of Cooley LLP’s Business and Technology practice in New York and an active participant in the New York startup and venture capital ecosystem. He teaches at Cornell University Law School, serves as a Tech Stars mentor and regularly counsels leading venture-capital firms and a broad range of venture-backed companies from inception through transformative transactions such as financings, mergers, acquisitions and IPOs.

Want to be an Entrepreneur Leadership Network contributor? Apply now to join.

Editor's Pick

Side Hustle

He Took His Side Hustle Full-Time After Being Laid Off From Meta in 2023 — Now He Earns About $200,000 a Year: 'Sweet, Sweet Irony'

When Scott Goodfriend moved from Los Angeles to New York City, he became "obsessed" with the city's culinary offerings — and saw a business opportunity.

Travel

Save on Business Travel with Matt's Flight's Premium, Only $80 for Life

This premium plan features customized flight deal alerts and one-on-one planning with Matt himself.

Science & Technology

Here's One Reason Urban Transportation Won't Look the Same in a Decade

Micro-EVs may very well be the future of city driving. Here's why, and how investors can get ahead of it.

Health & Wellness

Do You Want to Live to Be 100? This Researcher Has the Answer to Why Longevity is Not a Quick Fix or Trendy Diet

Ozempic, cold plunges, sobriety and the latest health fads are not what science reveals will help you live a longer and healthier life.

Data & Recovery

Better Communicate Data with Your Team for $20 with Microsoft Visio

Visio features a wide range of diagramming tools that can support projects across all industries.