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VCs are not generally in the business of receiving dividends. Venture capital funds generally set up to provide capital gains (i.e. a trade sale or an IPO) rather than for income for their investors. VCs prefer to plough any available profits towards the growth of the business in order to optimise any potential exit. In any event, most startup companies do not generate enough available profits to pay dividends. Dividends are typically only paid when the company has available profits and if declared by the board.
In UK venture capital transactions dividends typically take one of three forms:
- the first mechanic, which is the most company favourable, provides that any dividends are distributed to the ordinary shareholders and preferred shareholders pro rata (so everyone shares equally);
- the second mechanic requires that the preferred shareholders receive a non-mandatory, non-cumulative preferential dividend (typically between 6% and 12% of the original subscription price) before dividends are paid to holders of ordinary shares (the company will not be able to pay dividends on ordinary shares or any other shares in any year in which the prescribed dividend is not paid to the holders of preferred shares). As dividends are paid at the discretion of the board and are non-cumulative, then this percentage is not particularly meaningful and is designed as more of an incentive for companies not to pay a dividend;
- the third mechanic is that the investors require that dividends accrue and cumulate whether or not declared by the board (again typically at a rate of 6% to 12%). Companies should note that If dividends cumulate, unpaid accumulations will likely be added to the liquidation preference and redemption price (if any). Companies should be cautious of dividends that cumulate because the effect on total returns can be significant in the case of investments that do not exit for a number of years. It is worth modeling the impact of any cumulative dividends in conjunction with the liquidation preference. In addition, companies should realise that under UK GAAP and IFRS cumulative dividends may be regarded as liabilities that appear on the company’s balance sheet, which can lower the company’s ability to borrow.
The Anatomy of a Term Sheet series can be found in full here.