How are accured and unpaid dividends applied to the liquidation preference?

The term of the liquidation preference will almost always say that it is for the original purchase price (or a multiple of the purchase price) “plus accrued and unpaid dividends.” The addition of the “accrued and unpaid dividends” to the liquidation preference in most cases does not have any impact because venture capital investors do not expect to be paid any dividends. Dividends in venture-backed companies are never expected to be declared or paid.

However, investors will occasionally negotiate for a mandatory cumulative dividend right which is a mandatory obligation of the company to declare annual dividends that is cumulative so that any unpaid amounts in any one year are added to the next year. For example, if preferred stock has a mandatory cumulative dividend preference of $0.08 per share, and the dividend is not paid in 2007 then the investor will have a dividend preference of $0.16 per share in 2008. The dividend preference continues to grow from year to year as the company does not pay any dividends. Companies should not brush this issue off too quickly because the effect of the annual accumulation can become significant. Eventually, as your company hits a liquidation event such as an acquisition, all the dividend obligations that were left unpaid over the years will be added to the liquidation preference.

I think that it is still true that east coast venture capital firms are more likely to request cumulative dividends payable upon some liquidity event – but I don’t have any substantiating evidence of this except from my own experience with the deals that come through my practice. Venture capital firms based on the west coast usually do not cumulate dividends.

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