As a startup founder raising venture capital, it’s essential to understand the financial terms that may be included in your investment agreement. One such term is dividends, which can affect your company’s cash flow and the way profits are distributed among shareholders. In this comprehensive guide, we will explore what dividends are, why they might be included in the terms of a venture capital deal, and the potential implications for your startup.
What are dividends?
Dividends are payments made by a company to its shareholders, typically from its profits or retained earnings. These payments can be made in cash, additional shares of stock, or other forms of consideration. Dividends represent a return on investment for shareholders and are usually distributed on a per-share basis.
Types of dividends There are two main types of dividends that may be relevant for startups:
- Regular dividends: These are periodic payments made to shareholders, usually in cash. Regular dividends can be paid quarterly, semi-annually, or annually.
- Special dividends: These are non-recurring payments made to shareholders in addition to regular dividends, typically as a result of a significant event, such as the sale of a business unit or the receipt of a large windfall.
Dividend preferences in venture capital deals
In venture capital investments, dividends are often structured as a preference for preferred shareholders (i.e., the investors). This means that the investors receive their dividends before any dividends are paid to common shareholders (i.e., founders and employees). Dividend preferences can be structured in several ways, such as:
- Cumulative: If dividends are cumulative, any unpaid dividends will accrue and must be paid in full before any dividends are paid to common shareholders. This can increase the investors’ overall return on investment.
- Non-cumulative: If dividends are non-cumulative, unpaid dividends do not accrue, and there is no obligation to pay them in the future.
- Participating: Participating dividends allow preferred shareholders to receive their dividend preference and then also participate in the distribution of remaining dividends alongside common shareholders.
Legal wording of dividends
The National Venture Capital Association (“NVCA”; website: www.nvca.org) publishes a Model Term Sheet, which is a very useful tool. This term sheet can be found here: https://nvca.org/model-legal-documents/.
The NVCA term sheet model language for this type of dividend is:
“Dividends will be paid on the Series A Preferred on an as-converted basis when, as, and if paid on the Common Stock.”
The non-cumulative option is described by the NVCA Model Term Sheet as follows:
“Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board of Directors.”
The NVCA Model Term Sheet cumulative dividend provision is as follows:
“The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon liquidation or redemption]. For any other dividends or distributions, participation with Common Stock on an as-converted basis.”
Dividends in venture capital financing deals for startups are not very common. Most startups are focused on growth and reinvesting any profits back into the business to fuel that growth, rather than distributing profits as dividends to shareholders. Startups usually operate at a net loss in the early stages, as they invest in product development, marketing, and other growth-related activities.
Venture capital investors generally understand that investing in startups is a high-risk, high-reward proposition. Their primary goal is typically to achieve significant returns through capital appreciation when the startup achieves a successful exit, either through an acquisition or an initial public offering (IPO). As a result, the focus is more on the increase in the value of their shares, rather than receiving regular dividend income.
However, in some cases, dividends may be included in venture capital financing deals, usually in the form of a dividend preference on preferred shares. These dividend preferences are often cumulative, which means that if the startup is unable to pay the dividends in a given year, they will accrue and must be paid before any dividends are paid to common shareholders.
Including dividends in venture capital deals is generally more common in later-stage financing rounds, where the startup is more mature and generating profits. Even in these cases, dividends are still relatively rare compared to the primary focus on capital appreciation.
Why are dividends included in venture capital deals?
Dividends can be an attractive feature for venture capital investors for several reasons:
- Risk mitigation: Dividends provide a steady stream of income, reducing the reliance on capital appreciation for returns.
- Alignment of interests: Dividends can help align the interests of investors and founders by encouraging responsible financial management and the pursuit of sustainable growth.
- Tax considerations: Dividends may be treated differently than capital gains for tax purposes, offering potential advantages for investors.
Potential implications for startups
While dividends can be beneficial for investors, they may also have consequences for startups:
- Cash flow: Regular dividend payments can put pressure on a startup’s cash flow, particularly in the early stages when cash is often tight.
- Capital allocation: The obligation to pay dividends may restrict a startup’s ability to reinvest profits in growth initiatives or other strategic priorities.
- Valuation: Dividend preferences can impact the valuation of a startup, as they represent a claim on the company’s future earnings.
A numerical example of dividends
Let’s consider a numerical example to illustrate how dividends in a venture capital deal might work.
Suppose a startup raises $5 million in a Series A round of funding, issuing preferred shares to its venture capital investors with an 8% annual dividend preference. The startup has 1 million preferred shares and 3 million common shares outstanding (held by founders, employees, and early investors).
Assume the startup generates a net income of $1 million in the first year after the investment.
Now, let’s calculate the dividends for preferred shareholders and the remaining amount for common shareholders:
- Dividends for preferred shareholders:
Dividend preference = 8% (annual rate) Investment amount = $5,000,000 Preferred shares = 1,000,000
Total preferred dividends = 8% x $5,000,000 = $400,000
- Remaining net income for common shareholders:
Net income = $1,000,000 (generated in the first year) Remaining net income after preferred dividends = $1,000,000 – $400,000 = $600,000
- Per-share dividends for common shareholders:
Common shares = 3,000,000 Per-share dividend for common shareholders = $600,000 ÷ 3,000,000 = $0.20
In this example, preferred shareholders receive a total of $400,000 in dividends, while common shareholders receive a total of $600,000 in dividends, or $0.20 per share.
Keep in mind that this is a simplified example, and the actual calculations and distributions may vary based on the specific terms of the venture capital deal, such as cumulative, non-cumulative, or participating dividend preferences.
Understanding the role of dividends in a venture capital deal is crucial for startup founders. Dividends can provide investors with a steady return on investment and align interests, but they can also impact a startup’s cash flow and capital allocation decisions. As a founder, it’s essential to carefully consider the terms of any dividend arrangement and negotiate a deal structure that balances the needs of both investors and the startup.
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