Explaining investment terms: Dividend rights
Venture capital investors often invest in early stage companies that are in an intense growth phase. The objective is to grow the business and its value and to realise a return on investment (ROI), typically targeting a multiple of the amounts invested – on exit. In most cases such companies should be reinvesting all profits (without which a dividend cannot be paid) to continue growing the company, rather than paying dividends to shareholders. Sometimes there is a prohibition on the payment of any dividend, which may be for a limited period of time.
Even if the payment of a dividend is permitted, a common way of ensuring that a company is not obliged to pay dividends while it is growing is to provide the investors with a share class that has a preferential, cumulative dividend, usually fixed at a percentage of the purchase price paid for each preferred share. The company will also be prevented from paying any dividend to other shareholders until the dividend is paid to the holders of the preferred shares. Since that dividend cumulates usually until an exit, it effectively prevents any other dividend being paid until then. In addition, investors will often have an overriding right to veto the payment of any dividend.
If a dividend is cumulative, it means that for each period that the dividend accrues (e.g. quarterly or annually) any amounts not paid are cumulated until the company has the necessary cash. At that time the cumulated accrued amounts must be paid to the investors’ share class in their entirety, before any dividends can be paid to other share classes. If the preferred shares are converted into ordinary shares, the investors will usually expect all accumulated dividends to be paid or capitalised into ordinary shares on such conversion.
In addition to a dividend preference, venture capital investors typically require that the preferred shares be entitled to participate in any distributions on the ordinary shares, or in other words, to enjoy a pro rata share of any dividends paid to the ordinary shares on top of any dividend preference paid only to the preferred shares. Allowing preferred participation ensures that a company cannot declare a small preferential dividend to the preferred holders followed by a much larger dividend to the ordinary shareholders.
In some jurisdictions, escalating dividend provisions can be used to encourage the company to work towards an exit and to help its investors recover some of their investment if the company fails. These require the company, if it has not achieved a successful exit (see Exit) within a certain period of time, to declare and pay cumulative dividends to preferred shareholders at rates that increase each year.
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