Term Sheets: What do I need to know about Dividends?

This week we’re starting a series on key terms in venture capital (VC) financing deals.

This week’s question: What do I need to know about dividends?

Our answer: Dividends are a portion of your startup’s earnings distributed to stockholders, typically in cash or additional shares. For VC-backed startups, dividends are primarily used to benefit preferred stockholders who have preferential treatment on payouts. While dividends are common in mature and profitable businesses, startups (especially early-stage ones) rarely pay them. Instead, startups usually reinvest earnings into growth initiatives such as product development, market expansion and scaling operations.

However, even for early-stage startups that don’t expect to issue dividends soon, certain dividend types – especially cumulative dividends – can create significant long-term financial obligations that can hamper the company.

So before agreeing to a VC financing deal involving dividend, we recommend you discuss with potential investors whether they prioritize long-term valuation growth or steady cash returns to negotiate accordingly.

Balancing Investor Incentives and Startup Needs 

When considering how to balance startup and investor needs, keep in mind that there are two primary forms of dividends that preferred stockholders receive – cumulative or non-cumulative.

Cumulative dividends accrue over time and any accrued unpaid dividends must be paid before common stockholders receive any future distributions.

Non-cumulative dividends do not carry forward. If a startup doesn’t declare a dividend in a given period, those dividends are forfeited.

Cumulative dividends can attract investors by providing additional financial security, making your startup’s fundraising easier; however, this can also become a major financial burden over time. Non-cumulative dividends, while less appealing to investors, give your startup greater cash flow control and protect some of the upside for founders and common stockholders.

Why Dividend Discussion Matters

Even though dividends are infrequently invoked with startups, ​​understanding your potential investors’ priorities with dividends is critical because these discussions often serve as a “canary in the coal mine” providing you with early warning signs of future challenges and misalignment.

If your potential investors prioritize long-term equity growth, then non-cumulative dividends allow your startup to reinvest earnings and scale. However, if potential investors seek regular cash returns (perhaps seeking dividends in lieu of a traditional exit strategy such as a sale or initial public offering (IPO)), then cumulative dividends may be unavoidable.

Aligning the dividend structures with both your startup’s desired financial flexibility and your investors’ expectations is key for a successful and sustainable partnership.