A typical term sheet will include a non-cumulative dividend on the preferred stock -- usually set at between 8 and 10% of the purchase price per annum. While initially this may seem heavy-handed ("You are trying to tell me that they want dividends too?!?"), in practice, dividends are rarely a point of negotiation. The truth is that very few private companies pay (and few investors ever expect to receive) dividends. So dividends are rarely a major point of negotiation, however, sometimes the use of cumulative dividends vs. non-cumulative dividends do become negotiated. As you will read below, there can be a substantial difference between the two types of dividends.
Cumulative vs. Noncumulative Dividends
Sometime investors will seek cumulative dividends. As you will see in the data below, cumulative dividends are fairly uncommon (less than 10% of venture capital financings). However, they do occur and it is important to understand the distinction.
Cumulative Dividends means that the dividends will accrue no matter what the company does. Noncumulative dividends will only accrue and be payable if the company declares the dividends. This means that noncumulative dividends are much more company favorable than cumulative dividends.
To understand the implications, take the following example: A venture capitalist invests $3 million in both Company A and Company B. Company A has cumulative dividends set at 8% annually. Company B has noncumulative dividends set at 8% annually. Three years down the road, both Company A and B are sold. Now Company B must pay the venture capitalist $720,000 of accrued dividends, while Company A has no dividends to pay, since none were declared.
Common Practice: Cumulative vs. Noncumulative Dividends
Generally, these are not intended to be paid in cash because the start-up company needs the cash. However, cumulative dividends may be paid in connection with a redemption or at the time of a merger; or, in the event of a public offering, would be added as a premium to the rate at which shares of Preferred Stock are converted into Common Stock (this rate is usually one-to-one at the time of the financing).
Cumulative dividends can significantly increase the value of the investor's security, but they can also pose tax problems for the investor. As a practical matter, cumulative dividends aren't frequently requested. Dividends aren't a highly negotiated portion of the term sheet, although there may be some discussion regarding cumulative versus non-cumulative dividends.
Will the deal include cumulative dividends?
Percentage of financings that include cumulative dividends:
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