When negotiating venture capital investment, founders are often focused on valuation, equity dilution, and governance. However, financial terms such as dividend rights can have significant implications for a company’s future cash flow, investor returns, and capital structure.
What are dividend rights?
Dividends are distributions of a company’s profits or retained earnings to shareholders, typically in the form of cash or additional shares.
In the venture capital context, dividends are rarely paid out during a company’s early growth phase since companies typically want or need to reinvest earnings to scale their operations and investors generally expect to generate their returns through capital appreciation at exit as opposed to receiving income. Nevertheless, dividend rights can often be included in term sheets for more mature companies as a protective or value enhancing mechanism for investors.
Dividend rights are usually the preserve of preferred classes of shares held by investors and are expressed as a percentage of the original issue price of those preferred shares. For example, a 10% dividend on a £1.00 preferred share would entitle the holder to £0.10 per year. The structure of these rights can significantly affect how value is allocated between preferred and ordinary shareholders.
Types of dividends include:
Cumulative dividends
Cumulative dividend rights entitle preferred shareholders to receive a fixed dividend each year regardless of whether dividends have been declared or profits generated from which dividends can be lawfully paid. Unpaid dividends will accrue or accumulate and must be paid in full to preferred shareholders before any distributions are made to ordinary shareholders or as a priority payment to those shareholders on an exit. This structure protects preferred shareholders as it prevents profits available for distribution being allocated by a company disproportionately in favour of ordinary share classes .
Non-cumulative dividends
Under this structure, dividends do not automatically accrue and are only paid if they are declared by the board in a given year. This offers a company greater flexibility in managing its cash flow and is more commonly seen in early-stage deals.
Participating dividends
Participating rights allow preferred shareholders to receive their fixed dividend and then to also participate in any additional dividends paid to ordinary shareholders. This structure aligns investor interests with company performance and can significantly increase investor returns in profitable years.
Non-participating dividends
Here, preferred shareholders receive only their fixed dividend and do not share in any additional distributions payable on the ordinary share classes. This caps their return and leaves more upside for ordinary shareholders, which may be more favourable to founders and employees.
Investors may seek dividend rights for:
- Exit enhancement: Accrued dividends can increase the investor’s return upon a sale or liquidation.
- Risk mitigation: The income rights can provide a baseline return in scenarios where the company does not achieve a high-value exit.
- Negotiation leverage: In challenging fundraising environments, dividend rights may be used to balance other economic terms.
- Tax efficiency: In some jurisdictions, dividends may be taxed more favourably than capital gains.
Founders should carefully review any proposed dividend provisions and understand their long-term implications. For instance the cash flow impacts of dividend payments should be considered and how this might affect the company's ability to execute its growth plans. Obligations to pay dividends can also depress valuations since they represent a future liability which needs to be met.
Dividend rights are a nuanced but important element of venture capital financing. While they are not typically to be found in early-stage companies, their presence in a term sheet can significantly affect investor returns and founder economics at exit. Founders should approach these provisions with a clear understanding of their structure, purpose, and potential impact to ensure the terms align with their company’s growth strategy and capital needs.
DWF has the largest venture and growth capital group in the UK with over 85 lawyers in 10 offices, and supports investors and companies across several sectors including financial services, technology, media and telecommunications, life sciences and healthcare and real estate and infrastructure.
If you have queries on any of the issues covered in this article please contact one of our experts.
With thanks to Sonia Miah for her contribution.
