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โDefinitionโ A dividend is a distribution of a companyโs profit to shareholders. Preferred stock pays predetermined dividends,* while a companyโs board of directors must authorize any dividends to holders of common stock.* Many established public companies and some private companies pay dividends on common stock, but this is rare among startups and companies focused on rapid growth.* Startups rarely pay dividends on common stock because they generally prefer to reinvest their profits into expanding the business.
โcautionโ Companies backed by traditional venture capital firms will almost certainly not ever issue dividends. Because of this, most founders donโt negotiate on dividend rights in term sheets. Venture capitalists are looking for fund-returning results, not 6โ8% dividends. Negotiating on dividend terms at the Series A can be hazardous, as the company may inadvertently signal that theyโre interested in becoming a cash-flow positive dividend-distributing business, not a venture-scale fund returner.
Dividends come in two major types: non-cumulative dividends and cumulative dividends.
A non-cumulative dividend can be declared by the board and distributed to shareholders at any time. They are most common in venture-backed companies. Non-cumulative dividends are sometimes referred to as โif, when and asโ or โwhen, as and ifโ dividends. This comes straight from the language youโll find in term sheets related to dividends: โโฆif, when and as declared by the Board.โ Some non-cumulative dividends require the company to pay some percentage to preferred stockholders before any dividend is issued to common stockholders, which can become onerous if a venture-backed company should switch strategies to become a cash-flow positive dividend-distributing business.
A cumulative dividend accrues at roughly 6โ8% annually to be paid out on M&A or an IPO and are essentially a guaranteed return on investment. They are much more common in private equity or hedge-fund style investments.
โDefinitionโ A pay-to-play provision in a term sheet requires investors to participate, at the companyโs request, in subsequent financing rounds on a pro rata basis. If an investor does not participate when requested, they face consequences that can range from losing some privileges like anti-dilution protections to having their preferred stock wholesale converted to common stock.
Pay-to-play provisions are extremely rare in technology investment deals. But they are absolutely common in biotechnology or life sciences deals because those types of companies require such a large amount of capital to get a product to market. Early investors in biotechnology or life sciences companies need to be prepared to pony up cash in future financings and go the distance.
Learn more from the Startup Company Lawyer blog post, โWhat is a pay to play provision?โ