With the rather abrupt shift from a sellers’ to a buyers’ market unfolding in the venture capital space, entrepreneurs will see more investor-friendly terms cropping up in term sheets. Two recent Venture Best blogs looked at one such term – participating preferred stock – that will find its way in some form into most term sheets before the year is out. You can find the previous blogs here.
Another term entrepreneurs will likely start seeing again is cumulative preferred. Like participating preferred, cumulative preferred is mostly aimed at boosting investor returns in sideways exits. That is, it mostly protects against downside outcomes with progressively less impact as outcomes improve.
Cumulative preferred stock means that if a company suspends dividend payments, the money owed rolls over into the next dividend payment opportunity. If a dividend is not paid and the startup experiences an exit, then the investors can collect those unpaid (but accumulated) dividends as part of their liquidation preference. Of course, most venture-backed startups, even later stage, don’t pay dividends. Even most post-exit startups don’t pay dividends for many years. Instead, they invest whatever cash flow they generate back into growing the business.
So, the first thing to know about dividend provisions – cumulative or not - in venture deal sheets is that they are not so much about paying dividends as they are about preventing dividends from being paid to anyone before they are paid to the investors. They, in effect, block payment of dividends on common shares by requiring they be paid on preferred shares first.
Now the typical “blocking” dividend is non-cumulative, which means that if it is not declared in any given period, it goes away. If you don’t pay it in one year it “expires.” In contrast, a cumulative dividend rolls over if it is not paid. Imagine a $1.00 preferred stock with a 10% cumulative dividend. If in the first year, the $0.10 dividend is not paid, then the dividend due in the second year will, if paid, be $0.20. And, if not paid in the second year, in the third year the dividend will be $0.30. And … you get the idea.
Now, if dividends are never paid the cumulation feature might not have much significance. But paying dividends is not, as previously noted, what cumulative preferred provisions are all about. Rather it is about growing the liquidation preference, and thus boosting the investor’s preferential return on a sale of the company.
Let’s look at an example. Suppose ACME Ventures purchases 1 million shares of NEWCO preferred stock with a 10% non-cumulative dividend for $1 million. Also assume ACME owns 40% of NEWCO after the investment. Now suppose three years pass without any dividend being declared or paid, and NEWCO is sold for $2 million. Assuming ACME’s preferred has a non-participating liquidation preference, ACME will elect to receive its preferential payment of $1 million (the alternative, taking its 40% pro rata share of the proceeds, being just $800,000).
Now let’s suppose the same facts except ACME’s preferred has a 10% cumulative dividend (which is not paid). In this case, ACME’s preferential payment would be $1.3 million. That’s $300,000 more (the cumulated unpaid 10% dividend) for the investor. And, of course, $300,000 less for the common shareholders.
So, again, the take-home message with cumulative dividends is that they are not so much about paying dividends as they are about boosting investor returns in sideways exits. As with participating preferred, they are mostly about downside protection for investors.
Next time, redemption provisions. Which (spoiler alert) are not really about redemption.