NOTE: This is the third post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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The operative provisions in the NVCA’s model term sheet are grouped according to the NVCA model financing document in which they are found, beginning with the Charter, which defines the rights and preferences of the shares being purchased in the financing. The next several posts in this series deal with the terms in Charter.
Dividends
Dividend provisions are often overlooked by entrepreneurs, but can have a significant effect on the economics of a financing. The model term sheet includes two alternative dividend provisions, one providing that dividends will be paid only when also paid to the common stock (company favorable), and the other providing for “accruing” dividends on the preferred stock (investor favorable). In the second alternative, the more company favorable formulation provides that the preferred stockholders have a right to receive a dividend “only when and if declared by the Board.” If this language is not included, the right to receive dividends is not contingent on Board approval and unpaid dividends simply remain as obligations of the company to the investors.
It is important to note that in practice even accruing dividends not requiring Board approval are never (in this blogger’s experience) actually paid out in cash unless and until the company liquidates (and then only if there’s enough cash available, which there often is not); rather, typically they eventually convert to common stock when the underlying preferred stock converts (we’ll discuss conversion in a later post). Like interest on a debt, accruing dividends may “compound” periodically, meaning dividends accrue on dividends. The more frequently dividends compound, the faster they accrue.
The economic impact of dividends is most significant to the entrepreneur (and to the investor) if the company is eventually sold for a modest amount. If a company is wildly successful, the value of the accrued dividends relative to the rest of the company will be trivial, and if a company fails there won’t be any money to pay the dividend on liquidation. Between these extremes, however, dividends can take a significant bite out of an entrepreneur’s payout when a company is sold. Since few companies become wildly successful, entrepreneurs should try to eliminate accruing dividends, or at least reduce their effect by (a) keeping the dividend rate low (5-10% is the standard range in normal economic times), (b) insisting that the dividends do not compound and/or (c) providing that the dividends do not begin to accrue until some time in the future (typically 1-3 years from the date of the financing).