Whether you’ve only recently decided to seek out capital for your business or you have already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process. In this series we’ll look to shed some light on the legal language contained in a financing term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both the Company and the Investor. Check out an overview here.
When you take out a home loan or put money on your credit card, it is on the understanding that the bank (or other institution) lending you money will expect something back for the trouble. In the case of a traditional loan instrument that “payback” comes in the form of interest, generally described as a percentage of the amount initially lent (or “principal”).
In the equity financing world, the “payback” concept is instead captured by the notion of the “dividend”, or right to receive funds from a company solely because of the stock that you hold.
Let’s take a look at a few of the options.
The model NVCA term sheet we have been using as the basis for our discussion lists three alternatives for the dividend concept. They are as follows:
Alternative 1: Dividends will be paid on the Series A Preferred on an as‑converted basis when, as, and if paid on the Common Stock
Alternative 2: The Series A Preferred will carry an annual [__]% cumulative dividend [payable upon a liquidation or redemption]. For any other dividends or distributions, participation with Common Stock on an as-converted basis. 
Alternative 3: Non-cumulative dividends will be paid on the Series A Preferred in an amount equal to $[_____] per share of Series A Preferred when and if declared by the Board.
The model also includes (as a footnote to the second alternative), the following note which is fairly self-explanatory (“conversion” in the note refers to the conversion of the series preferred into common stock):
 In some cases, accrued and unpaid dividends are payable on conversion as well as upon a liquidation event. Most typically, however, dividends are not paid if the preferred is converted. Another alternative is to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value. The latter are referred to as “PIK” (payment-in-kind) dividends.
Let’s break down the options presented.
Under “Alternative 1” the preferred stock sold in the offering would receive dividends, but only in respect of the common stock into which the preferred could convert (the preferred stock does not actually have to convert to be entitled to the dividends; that is the meaning of the term “as-converted” which you will see throughout the model term sheet). Said another way, the preferred stock really gets nothing that the common stock doesn’t get. This alternative is the “cheapest” for the Company to give, as the preferred really gets no bonus from its use.
(In terms of relative “expensiveness” of money, particularly for early investment rounds, it is normal to consider the Company, which at this point usually consists entirely of its founders and their friends and family, as “being” the common stock. Thus, preferred provisions that take money out of the hands of the common stock are “expensive” while preferred provisions that do not do so are “inexpensive” or “cheap”.)
Under “Alternative 2”, the preferred stock would receive dividends equal to a set percentage of the investment amount represented by such stock “cumulating” (or “accruing”) from its date of issuance. Usually this is calculated on an annual basis (generally between 6-15%, with the most common in my experience being 8%), and though not stated expressly in the model term sheet, is to be paid before (i.e., in “preference”) to any dividends paid on the common stock. As you can see by the second sentence of this alternative, the stock receiving such rights would also participate in any dividends paid to the common stock. This makes Alternative 2 by definition more “expensive” to the Company than Alternative 1 (as it is inclusive of Alternative 1 in its entirety).
Alternative 2, then, is really the “interest” alternative. It reflects what we usually see in traditional debt payments: additional amounts a borrower owes to a lender/investor because of the risk that full repayment might never occur.
Finally, under “Alternative 3” a distinction is made between the cumulative dividends referenced in Alternative 2, and the non-cumulative dividends referenced here. In truth, a significant number of attorneys don’t fully understand (or draft definitive documents reflecting) this distinction correctly. Non-cumulative dividends are dividends that are owed in preference to common stock dividends, but are not being “earned” in the same way as cumulative dividends. Said another way, they are dividends that must be paid to the preferred before the common stock is paid any dividends of their own, but if no dividends are paid in a given year then they are not otherwise owed.
As a comparison between Alternatives 2 and 3, imagine that Company 1 has sold stock bearing 8% cumulative dividends (Alternative 2) and Company 2 has sold stock bearing 8% non-cumulative dividends (Alternative 3). Neither company makes any dividend payments in Year 1. In Year 2, both companies seek to make dividend payments to their stockholders. Company 1 must pay 8% for Year 1, 8% for Year 2, and then the remaining dividend amount. Company 2 must pay 8% for Year 2 but can then pay dividends to all of its stockholders. For Company 2 the Year 1 preferred dividend obligation simply doesn’t exist, because the company’s board never “declared” any dividends in that year.
(Note that the above example assumes dividends calculated as simple interest. Compounding interest is also a possibility (as are a number of other distinct permutations). As always, the NVCA model is simply a starting point. Financing terms come in all forms and flavors.)
So Alternative 1 is the “cheapest”, Alternative 2 is the most “expensive”, and Alternative 3 falls somewhere in-between.
What a Company or Investor winds up accepting in respect of dividends, together with what it accepts in respect of liquidation preferences (discussed later in this series), is a large step in determining the economics of the investment in question. As with most economic terms, the dividend term will in large part depend on the relative leverage of the entities involved, the market standards for the time, and just how desperate the Company is for cash at the time.
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at email@example.com.