The Cumulative Dividend

In connection with term sheets and the raising of capital, dividend preferences (a dividend is an annual distribution of profits to shareholders, generally paid in cash or stock) are rarely a meaningful negotiating point, for three main reasons.FN1 First, investor-backed start-ups rarely generate profits early on, so there's probably nothing to distribute and the issue is moot. Second, even if that doesn't prove the case, the founders understand any profits should be re-invested in the growth of the company. Third, unlike, say, private equity guys (who are investing big money (usually more than $50MM) with lowered expectations for return multiples on invested capital), VCs and angels are less focused on percentage annual yields than the long term multiple they'll get back from the investment. "The juice," as one commentator says here, "from the dividend is nice [for VCs], [but] it doesn't really move the meter in the success case".

What you get in 10% or so of financings,FN2 however, is investors asking for dividends that accrue and accumulate from one year to the next. Such dividends are called "cumulative' and are akin to roll-over minutes with a phone plan. To the extent a dividend is not declared (by the BoD) during a particular year, the dividend is carried forward to the next year. (Non-cumulatives (“when, as and if declared” dividends) do not carry-over).FN3

The argument from investors is that the cumulative dividend is necessary as reasonable down-side protection to guarantee a minimum annual rate of return on investment (often in the range of 5-10%).FN4

This wouldn't have an immediate impact on the company's cash position but if the investment remains outstanding for an extended period the effect could be large (and also generally doesn't reflect well (to future investors, potential lenders (i.e. creditors, etc.) on a balance sheet since the dividends are liabilities).

The move for the company is to concede to cumulative but establish conditions that ensure the cumulative dividends act as a protective device rather than a windfall. Allow unpaid accumulations to factor into the liquidation preference (or maybe even the redemption price) but not the conversion price (the rate at which the preferred stock converts into common stock).

The former scenario is not only the most common formulation - giving investors an increased share of the proceeds in the event of a sale - but the one that best serves to return investors some portion of their money back in the event the company needs to be sold on the cheap or liquidated due to insolvency.

The latter scenario, however, could have an enormous impact in the case of a successful company exit (e.g., an IPO) because it increases the investor's pro rata entitlement to proceeds and should be resisted for this reason (absent a cap to the investor's return or some other special story).

FN1. Language in term sheet in connection with dividends will read something like, "Dividends: The holders of the Preferred shall be entitled to receive [non-]cumulative dividends in preference to any dividend on the Common Stock at the rate of [x%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of the Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis.”

FN2. 10% number is from Fenwick and West, reporting in 2010.

FN3. If the non-cumulative is not declared by the BoD at year's end, it is extinguished and begins accruing anew the following year.

FN4. The logic of this can be deceptive. In a way it seems reasonable for the investors to receive some kind of interest return (in the form a dividend) for the time value of their investment. But note that investors have (almost always) an uncapped upside participation right. That's what they're buying: an equity instrument not a debt instrument.