Beware the Cumulative Dividend

By: Paul A. Jones

Today’s topic is cumulative dividends, a term sheet nuance that is often overlooked by entrepreneurs. In most early stage angel/venture term sheets, the dividend section is frankly not very important in the grand scheme of things. But now and again you might see the word “cumulative” in the dividend section of your term sheet, and when do, you should give the matter your full attention.

In the typical venture capital deal, the preferred stock issued to investors will have a “dividend preference” in the form of a right to receive dividends at some rate prior and in preference to payment of any dividends on the common stock. The critical point is that absent the inclusion of the word “cumulative” (or in some constructions the words “cumulate” or “accumulate;” you get the idea) there is no requirement that dividends be declared and paid, or, if not declared and paid, that they are carried over to future years.

Assume a preferred stock issued for $1.00 per share with a 10% dividend preference. In practice, this means that the company cannot pay a dividend on the common stock unless and until it has paid a dividend of $0.10 per share to the preferred stock. But there is no requirement that any dividend be paid in any given year, and no consequences if it is not paid in any given year.

Now assume that the preferred stock, again priced at $1.00 per share, includes a “cumulative” 10% dividend preference. In this scenario, the company is still prohibited from paying any dividend on the common stock unless and until it has paid $0.10 per share to the preferred stock, and the company still does not have to pay any dividend in any given year. However, if the company does not pay the preferred the $0.10 per share dividend in a given year, that dividend rolls over – accumulates – to the next year. Which means that the dividend preference in the second year is $0.20 per share. If the dividend preference is not paid in the second year, it rolls over to the third year, making the dividend preference in the third year $0.30 per share and so on.

Now, in so far as most early stage high impact businesses have no intention of paying dividends until some remote time in the future, accumulating what amount to dividend IOUs might not seem like such a big deal. And in fact, if/when you are one of those rare startups that exits via an IPO that forces the conversion of your outstanding preferred stock, it probably won’t be a big deal. On the other hand, if your startup exits via a sale to another company, your accumulation of unpaid preferred dividends might cost you dearly. Why? Because the section of the term sheet that governs distributions to shareholders when the company is sold, somewhat misleadingly labeled “liquidation preferences,” almost always provides that among the sums that must be paid to the holders of preferred stock on such a sale, before anything is distributed to holders of common shares, are any and all accumulated but unpaid dividends.

To be sure, accumulated but unpaid dividends, in the grand scheme of things, may not amount to all that big of a deal. At least not if you have a blow out exit sale. On the other hand, if your exit transaction is more modest, the impact can be quite material.

Another example.  Let’s posit that your capital structure at the exit consists of 3,000,000 shares of preferred sold for $1.00 per share with a 10% never cumulative dividend that has never been paid, and 3,000,000 shares of common.  The preferred was issued five years prior to the exit transaction (so the accumulated unpaid dividend is $0.50 per share, or $1,500,000).  Finally let’s assume the exit proceeds available for distribution to shareholders after the sale of the company total $9 million.  In this scenario, assuming your preferred was fully participating, the preferred dividend will entitle the preferred shareholders to $750,000 more of the exit proceeds (and the common $750,000 less).  (If your preferred was not participating, there would be no damage on these facts.  You can play with the
numbers with this spreadsheet: CumulativeDivSheet_PAJ — 14623963 v1.  Note that the cumulating dividends become much more of a problem for the common in the case of a smaller exit value: in the example, plug $6,000,000 for the exit value into the spreadsheet, with 10% accumulating dividends for 5 years: the accumulating dividend results in non-participating preferred returns equal to what they would have been had the preferred been of the participating variety.  Ouch. )

The above analysis suggests that entrepreneurs should always push back when they see cumulative dividends in a financing term sheet. That said, the notion of cumulative dividends might have some merit in select deals, notably those rare early stage investments where the company really does expect to have cash flow to support paying dividends right out of the gate. There are cases where the entrepreneur’s pitch includes the ability to pay dividends at some point in the not too distant future, in which case the dividend provision can specify that dividends will cumulate but only at that future date. Even in these cases, however, entrepreneurs would be wise to push out the start date for cumulating dividends; as with most entrepreneurial forecasts, it almost always takes at least a little longer to reach cash flow positive operations than initially thought. And, frankly, even when cash flow from operations turns positive the company might be better served by investing the cash in the business rather than writing checks to investors.

In conclusion, the dividend provisions of the typical venture capital term sheet are usually not among the more critical or contentious subject of negotiations. However, when those provisions include words like cumulate, entrepreneur beware.

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