Ask the Wizard

When entrepreneurs are raising Venture Capital, it seems like attention and focus are weighted 80% to pre-money valuation and a couple percent each to all the other terms, and I think this is a mistake. I've talked previously about obsessing over pre-money valuation in an early round (seed, A, B) at the expense of other terms, and I'll start talking about some of these other terms now in a series of posts. I'll try to interlace these posts with operations and company structure posts to keep things interesting for everybody.

Today's VC term sheet topic is Dividends. FeedBurner investor Brad Feld wrote about this topic extensively in one of a series of posts about Term Sheets from the VC perspective. I'm going to copy Brad's typical Dividend section language here and discuss it briefly from the entrepreneur perspective.

"Dividends: The holders of the Series A Preferred shall be entitled to receive [non-]cumulative dividends in preference to any dividend on the Common Stock at the rate of [8%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of Series A Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis."

The first thing to point out is that you should pay careful attention to the areas in here that will vary from deal to deal. Brad has done a good job of highlighting these. There are three of them and I'll talk briefly about each. Before I do that, let's briefly consider the "founding fathers' intent" behind the dividend section. The explanation you will sometimes get from Venture Capital investors is that the dividend is just there in case the deal goes sideways (not a home run, not a complete bust), and it therefore provides for some return on investment at some point that juices the investment and drives some value back to the investors. As Brad note in his post, "...[they] don't provide venture returns, they're simply modest juice in a deal."

So, as an entrepreneur, you would like to minimize the impact of any dividends you have to pay out. To simplify it in the extreme: Automatic cumulative dividends bad, non-cumulative non-automatic dividends good. If you're accruing an automatic cumulative 8% dividend on the investment dollars, you won't like what those kinds of numbers start to look like in year 5 and year 6. More importantly, cumulative dividends are an accounting nightmare and you will spend more time than you care to even know working with your finance team and auditors on how you should account for cumulative dividends and their effects.

Fortunately, Brad's typical language above makes our job easy, and we can quickly highlight what you want to negotiate in your term sheet. You want three things: a) you want non-cumulative, not cumulative, Dividends; b) you want the lowest possible dividend percent, let's say 6%; c) you really want "when and as declared by the Board" in this section because the board will include operating executives of the company, perhaps a founder, and different investors, and these will rarely, if ever, be declared.

Having said all this, an obvious question that arises is "if non-cumulative when declared" is so benign, why not negotiate the section out altogether? Obviously you can try to do whatever you want, but one thing any private equity investors are going to look to do in any deal is look for some opportunities to manage the downside risk. This is one of those sections, and just get this sucker to the point at which it causes you no pain. Non-cumulative when and as declared by the board is reasonable and causes you no pain.

I would suggest you read all of Brad's Term Sheet posts if you're out raising money. Brad writes in a very common sense way that generally reflects both sides of the discussion about Term Sheets.