What is a dividend preference?

May 30, 2007

I have never encountered a private venture-backed startup company that paid a dividend, except in connection with a spinoff or other distribution to stockholders that might trigger the dividend preference of preferred stock.  Most startup companies do not generate enough cash to pay dividends and investors typically do not expect actual dividend payments.

Dividends are typically only paid when and if declared by the board.  If a company pays dividends, then holders of preferred stock receive dividends before dividends are paid to holders of common stock.  Typically, dividend rates range from 7% to 12%, varying somewhat to match interest rates.  If dividends are only paid at the discretion of the board, then this percentage is not very meaningful.

In some financings, the investors may require that dividends accrue and cumulate whether or not declared by the board.  Cumulative dividends are more prevalent in East Coast venture financings than West Coast venture financings.  According to WSGR data, non-cumulative dividends are much more common than cumulative dividends.

If dividends cumulate, companies will want all previously accrued but unpaid dividends to be waived upon the automatic conversion of the preferred stock. In contrast, investors will want the unpaid dividends to be paid or to be converted into common stock upon conversion or liquidation.

Companies should be wary of dividends that cumulate because the effect on total returns can be significant in the case of investments that remain outstanding for several years. If dividends cumulate, unpaid accumulations will be added to the liquidation preference and may be added to the redemption price, if applicable. In addition, companies should realize that cumulative dividends are liabilities that generally appear on the company’s balance sheet, which may lower the company’s ability to borrow and affect solvency analysis.

Comments

  • FeFe123

    What does an investor typically expect out of a new company if it is not dividend payments or dividend stock? I am considering business equity to my family members who invest. But what will that mean for them??

  • http://www.startupcompanylawyer.com Yokum

    @FeFe – Investors in technology companies expect a liquidity event (i.e. sale of company or IPO). Dividends may be appropriate in closely-held companies or S corps.