Dividend Rights - Term Sheet Provisions
What are Dividend Rights for Equity Investors?
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Table of ContentsWhat are Dividend Rights?
What are Dividend Rights?
Dividend rights are a common attribute of preferred stock and are detailed in the bylaws. Early-stage investors are rarely concerned with dividends; nonetheless, the parties will address dividend rights as a method of controlling the decision to issue a dividend. Dividend rights may be structured in a number of manners, which is almost always done in comparison to common shareholders. The dividend may state a dividend right as a percentage of issue price of the shares (generally 6 - 12% to match interest rates on debt), which represents some conversion rate to common stock.
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The most common methods of structure dividend rights are as follows:
- Cumulative vs Non-Cumulative Dividends - Cumulative dividends accumulate when a dividend is not issued by the business. That is, if no dividend is issued in a given year, then the amount that would have been issued accumulates for the preferred shareholder. If the company provides a dividend at any point in the future (or the company is sold or the preferred shares are redeemed), the preferred shareholder is entitled to the amount of all accumulated dividends. This entitlement gives the preferred shareholder priority over common shareholders in receiving the entitled dividend. The amount of the dividend is calculated as a percentage of share prices and the final payment may be based on simple or compound interest on the dividend amount. Companies will generally negotiate to waive accrued preferred dividends if or when the preferred shares are converted to common shares. The dividend is used as a protection device for the preferred shareholders. Upon conversion, preferred shareholders should be relegated to the same position as common shareholders (including dividend rights).
- Participating Dividends - Preferred shareholders participate in any dividends issued to common shareholders. The amount of the preferred dividend may be equal to common shareholders (calculated on an as-converted basis) or any multiple of the common shareholders dividend.
Startup venture cannot generally afford to issue dividends. The nature of the growth-based venture is that all available funds are reinvested into growing the business. As such, startup ventures generally incur extensive losses throughout the growth process. The operational costs above revenue are financed by the funds provided from outside equity investors. Investors well understand this objective and do not expect a dividend. If the company is able to distribute a dividend, then this is a negative signal to investors regarding the business growth path.