When negotiating a VC term sheet, dividends are often not the main focus. This is because compared to other terms like liquidation preference and valuation, they do not always have as large an impact on the payout to VCs and company management. However, dividends should not be overlooked, as they have the potential to have a significant impact under the right circumstances.
Dividends are often considered a downside protection for VCs. In other words, if the company does well and has a large and favorable exit, the dividends do not have a large impact on the payout to the VCs or management. In contrast, if the company underperforms and has a less-than-hoped-for exit, the negotiated dividends are often a significant factor in determining the payout.
For example, consider the simple case of a company with a single VC investor. The VC purchases 50% of the company for a $10M investment. Although the company initially projected a $50M exit, after 5 years things are not going well and they decide to sell for $20M. If the deal includes no dividends, the VC will be entitled to $10M of the proceeds (assuming a 1X liquidation preference -see our post on this topic), and the management will get the other $10M.
Now consider the above scenario with the addition of a somewhat typical 10% dividend. In this case, the VC would be entitled to 10% of its investment, or $1M, for each year that has passed. Since it’s been 5 years, the VC gets a total of $15M of the $20M sale ($10M for the liquidation prefence and $5M for the dividends), while the management are left with only $5M.
Things can get further complicated when you consider the issue of compounding. Some dividends come with a compound rate, further increasing the amount owed to the VC upon exit. Some dividends are also payable in stock instead of cash, meaning the VC will own a larger percentage of the company the longer the exit is delayed.
So although dividends may not have a huge impact on the proceeds of a successful exit, they can have a large impact on payouts when the company exits for less than expected, or if the exit is significantly delayed.