The Term Sheet: 5 Ways Dividends Work in VC Term Sheets for Investors
Dividends may sound particularly interesting to the average person when it’s understood that they represent a steady flow of regular and periodic income. However, in the venture capital world, dividends typically don’t matter that much, mainly because they pale in size compared to the potential profits of selling a big company success altogether. Ergo, folks don't stress so much about how dividends work with venture capital. That said, dividends do have a place and value if the average holding period is ten years, which means they get mention in term sheets for an investment agreement. And they particularly matter when one is dealing with a company that sounds like it has a great idea but struggles year after year to actually produce, such as a company like Twitter.
So here are five ways term sheets dividends can be protected, provided for and handled in terms sheets, without being restrictive to the company being invested in and supported:
- Contingent dividends. Not every startup has dividends from day one. It’s often understood by everyone involved that there is no profit whatsoever during the immediate growth phase because the company is trying to create a presence that will translate later into a revenue stream. However, that doesn’t mean an investor should not get any portion of revenues when they finally do manifest. A contingent clause ensures that preferred stock gets a specified percentage of profits if they occur before any other kind of distribution can be decided upon. The clause acts like a necessary cost to the company, one that has to be paid before anything can occur with net revenues, especially any kind of payouts to common stockholders.
- Gravy on top. There’s no question that dividends will not return an original investment in 99 percent of the cases. However, when one realizes what they do represent, above and beyond the investment return, it’s a bit like gravy on top of a good meal. The dividends don’t pay back the investment made per se, but they are an additional gain on top of the eventual investment payment, ergo the extra benefit.
- Should it be stock or cash? The answer to this question depends on the viability of the company and its product. There is no default answer. A startup with a real winner of a product would probably argue for more stock and more ownership. However, some VCs want cash as fast as possible to reposition elsewhere. Every case is different. However, what is important is to make sure a clear decision is made one way or the other and the terms reflect it. Otherwise, an investor could find itself getting paid with useless stock versus real cold cash.
- Automatic or no? Dividends shouldn’t be forced just to create some kind of a minuscule revenue stream. A short-term pinch for pennies can often cost a new company its valuable life-blood to do more and become a bigger success a year or two down the road. There’s been many a case when a required dividend has forced a company into the red and bankruptcy versus being more of a success.
- Don’t mix dividend types. It can be extremely attractive to provide a combination of dividend types, like options, cash or stock or all three, just to pay a dividend. First, it’s an accounting nightmare that not only has to be tracked but documented because the IRS pays close attention to options. Second, a combo payment often ends up looking like any easy way to increase company liquidity. If things are that tight, a dividend shouldn’t be paid in the first place since it could mean the difference of a growing company or one losing money.
Again, startup terms sheet and dividends are rarely, if ever, going to produce the kind of return that restores an initial investment. However, there's no reason that they should be ignored altogether when investing in startups. Dividends are a sign of a healthy, growing company and are a viable reward for a good bet. Treated correctly in a VC agreement, they can provide an additional reward without influencing or drawing away from the company's success curve.
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