Common Fundraising Questions: What Are Preferred Shares and What Makes Them So Preferable? Part II: Dividend Preferences

This is the second in a series of articles aimed to provide information to early-stage startups that are looking to raise significant funds by selling shares in the startup to investors. Please see our first article about Preferred Shares here.

When negotiating the specific terms for an investment in a startup, a common investor ask is for a dividend preference which gives the investors a first bite at the ‘dividend’ apple. If you’re new to this term, here’s what you should keep in mind:

What is a Dividend?

A dividend – also known as a “distribution” – is a payment made by a company to its shareholders.

A dividend is usually the only way for a company to get money to its owners unless those owners are also employees or service providers to the company. And a dividend is usually the only way an owner can make money from her shares other than by selling her shares to somebody else.

What does that mean for a startup? In practical terms, if the startup has (finally!) started generating real money and the founders want to transfer some of funds over to themselves personally, the company has to issue a dividend. Normally when a company issues a dividend, each stockholder gets a pro rata portion of the dividend – i.e. a shareholder owning 1% of the company gets 1% of the total dividend.   

There are two kinds of dividend preferences to look out for: a cumulative dividend preference and a non-cumulative dividend preference. 

What is a Non-Cumulative Dividend Preference?

If a class of Preferred Shares has a Non-Cumulative Dividend preference, the company has to issue an annual dividend just to the preferred shareholders if the company is going to issue any dividends at all. The size of the dividend preference is usually either a set amount per share (e.g. $2.00 per share) or a set percentage of the purchase price of the share (e.g. 8.00% of the purchase price per share).

Generally speaking, a company cannot issue any dividends to the stockholders as an entire group (so, including the common shareholders) unless the preferred shareholders have already received or will simultaneously receive their preferred shareholders-only dividend. 

However, the word “Non-Cumulative” means that a company doesn’t actually have an obligation to issue a preferred shareholders-only dividend – it just needs to do that if it wants to issue any other dividends in the same year. And if a company doesn’t issue any preferred shareholders-only dividend in a year, the preferred shareholders can’t demand payment of that missed dividend later on.

What is a Cumulative Dividend Preference?

A Cumulative Dividend Preference works the same way as Non-Cumulative Dividend Preference except that the preferred shareholders have the right to their preferred shareholders-only dividend each and every year, even if the company doesn’t issue dividends to any other shareholders. This means that if the company doesn’t issue any dividends for 1+ years – a very common situation with startups, since all extra cash is usually reinvested back into the business -- the preferred shareholders still have the right to those missed payments.

No matter how many years have passed, all those missed dividends have to be issued before the company can issue any other dividends. And in the event the company is sold or is liquidated, the preferred shareholders need to get all those dividends before any other company cash is distributed to any other shareholders.

Why Have a Dividend Preference? How Common Are They?

Dividend Preferences, especially a Cumulative Dividend Preference, ensure that investors get some ongoing return on their investment. As such, preferred shares with a dividend preference are very common in the corporate world.

That said, Dividend Preferences are significantly less common with startups, especially early-stage startups – you’ll see them much less often than you’ll see a Liquidation Preference (see our article about Liquidation Preferences here). That’s because investors usually want startup founders to take any extra profits they might generate in their early years and reinvest them into the business. Since that leaves no money left for any dividends, many investors don’t care enough to try and ask for this kind of preference. However, a Dividend Preference is certainly not so rare you’ll never see it in a deal – different investors have different priorities.

For the same reason, if you do see an early stage company offer Preferred Shares with a Dividend Preference, it’s usually a Non-Cumulative Dividend Preference since that doesn’t require the company to keep money in reserve on a continuous basis for dividends.

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Disclaimer: This article constitutes attorney advertising. Prior results do not guarantee a similar outcome. MGLS publishes this article for information purposes only. Nothing within is intended as legal advice.

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