Issuers and investors are well advised to document their deal in a term sheet. Though generally non-binding, they add significant value. Detailed term sheets raise issues early when there is still ample negotiating time. They also make drafting the definitive documents more efficient, saving on legal fees. However, parties must be vigilant to document the deal properly, especially when using terms of art.
For example, one commonly negotiated item on preferred stock is the dividend. Dividends can be cumulative (aka accruing) and either simple or compounding. The terms “cumulative” and “compounding” are sometimes (incorrectly) used interchangeably. But the differences are measurable in real dollars.
Dividends are one feature that makes preferred stock preferable. Dividends are structured in (at least) three common ways. NVCA publishes a sample term sheet that includes these options.
- Dividends can be paid on the preferred when (and if) they are paid on the common. The preferred holders have no dividend preference – they are treated as common holders and paid as if converted to common.
- Dividends can be paid on the preferred when (and if) declared by the Board of Directors. If the Board does not declare dividends, they are forfeited. Here, the preferred holders enjoy a preference on dividends but may not receive them.
- Finally, as described in detail below, dividends can be cumulative and perhaps even compounding.
Cumulative vs. Compounding
Emerging companies rarely have the ability to pay dividends to preferred holders. As a solution, companies often agree to pay dividends upon a liquidity event (e.g., sale of the company). But how much will investors receive? This is where the terms of art (cumulative, accruing, compounding, simple) become very important.
Cumulative (aka accruing) dividends provide investors with a certain annual return, typically expressed as a percentage of the original per share price of the preferred stock (e.g., “8% of the Series A Original Issue Price”). Thus, the term “cumulative” refers to the fact that dividends accrue over the years and will be paid upon a liquidity event.
Cumulative dividends can be calculated on a simple or compounding basis. “Simple” means the dividend is based only on the original per share price. “Compounding” means the dividend is based on the original per share price plus the dividends that accrue over time. Thus, the terms cumulative and simple refer to how cumulative dividends are computed.
For example:
Cumulative and Simple (aka Non-Compounding):
Suppose an investor invests $50,000 and receives 100,000 shares of preferred stock ($0.50 per share) with an annual 8% cumulative, simple dividend. In 5 years, the company is sold. The 8% annual dividend is calculated on the original per share price. The investor has earned $4,000 in dividends each year and, upon liquidation, the company must pay the investor $20,000 in dividends.
Cumulative and Compounding:
Suppose the same facts, but dividends are now cumulative and compounding. The 8% annual dividend will be calculated on the original per share price and on the accrued and unpaid annual dividends that accumulate over the years. This is similar to a promissory note with compound interest: the original per share price is like “principal” and the 8% annual dividend is like a compounding 8% interest rate. In this scenario, the investor earns $23,466.40 in dividends.
Clearly, there is a measurable difference between simple and compound dividends. And at first glance, the $3,466.40 difference may not seem overly significant. But the proper use of term sheet terminology has a greater value. A detailed and thoughtful term sheet helps maintain deal flow and good will during negotiations, can decrease legal fees and helps avoid disputes down the road. For issuers and investors at the outset of a long friendship, these benefits can be immeasurable.
