Continuing our series on key term sheet provisions, this week we will be taking a look at dividends.
What Are Dividends?
Dividends are distributions of company cash (or stock) to shareholders, and are most typically issued by mature companies. It is very rare for start ups and emerging companies to have extra cash to give back to shareholders. Dividends are only issued if authorized by the board of directors, and directors have nearly complete discretion in determining if and when they opt to distribute company cash to shareholders rather than opt to reinvest the money back into the company.
Stock Dividends vs. Cash Dividends
Dividends are most commonly issued in the form of cash disbursements. But dividends can be structured in the form of stock distributions, which dilute all shareholders that don’t participate in the dividend distribution. It is important for the company to consider the effects of dilution prior to agreeing to distribute dividends in the form of stock.
Cumulative vs. Non-Cumulative
Dividends can be either cumulative or non-cumulative. Non-cumulative dividends lapse annually if directors opt not to issue dividends. In contrast, cumulative dividends accumulate and remain on the books until the company authorizes dividends, or until a liquidation event occurs (here, the sale of the company would count as a liquidation event, but an IPO likely would not).
Cumulative dividends have some important side effects that should be considered from the outset. Dividends that accumulate annually can be difficult for accounting reasons, especially if the company has the option to pay the dividends in cash or stock. Also, cumulative dividends can have the unintended side effect of putting a company in a zone of insolvency as the unpaid dividends remain on the books and are generally part of the solvency analysis.
Stockholders of preferred stock can have the same rights to receive dividends as common stockholders, or they can participate in preference. That is, preferred stockholders may negotiate for the right to receive all of their dividends before common stockholders receive any of their dividends.
The Importance of Dividends in Term Sheets
Dividends are often not as important to investors in start-ups as many of the other terms. Start-ups rarely issue dividends, and if the company is successful, the money accrued from dividends will be a relatively small portion of the return on the investors’ investment. However, when the company is sold at a lower valuation, dividends can be a relatively large portion of the return. How important dividends are depends on the upside of the company, and the personal preferences of the investors.