Term Sheet Template - National Venture Capital Association (Page 5 of 25) in pdf

when and if declared by the Board and prior to any dividends to any

other class.

]

[Alternative 2: The Series A Preferred Stock will carry an annual

[__]% cumulative dividend

[compounded annually], payable upon a

liquidation or redemption. For any other dividends or distributions

give the Series A Preferred Stock Investor a limited preference by making sure that if there is money available for

dividends, it will be paid first to the Series A Preferred Stock Investors.

A dividend may be participating or non-participating as follows:

(a) after preferred preferential

dividends, new preferred does not participate in further dividends, (b) after preferred preferential dividends, new

preferred alone participates in dividends on the common, (c) after preferred preferential dividends, new preferred and

other specified series participate in dividends on the common, (d) after preferred preferential dividends, common gets

specified dividends then new preferred alone participates pro rata in additional dividends on common, OR (e) after

preferred preferential dividends, common gets specified dividends then new preferred and other series participate pro

rata in additional dividends on common.

With a cumulative dividend, the dividend is calculated each year and the right to receive the dividend is

carried forward until either it is paid or the right to receive the dividend is terminated in some way. Thus, there is no

need for the dividend to be declared by the Board in order for the right to receive the dividend to accrue. However, the

dividend will not actually be paid unless an event requiring payment occurs, such as a fixed payment date, a conversion

to Common Stock, liquidation or a redemption.

Sometimes, a term sheet provides that the cumulative dividend will begin to accrue at some time in the

future rather than at the time of investment. This is most often done in early stage financings. The delay will typically

be one to three years in length.

Alternative 2 is the approach most favorable to the Investors, of those approaches presented. Investors

expect to earn their preferred dividends based on how long the Investors have dollars invested in the Company. Thus,

this approach has some characteristics similar to an interest charge including, usually, some level of compounding.

In some cases, accrued and unpaid dividends are payable upon conversion as well as upon liquidation or

redemption. Typically, however, dividends are not paid if the Preferred Stock is converted. The underlying theory is

that Investors are required to make a choice of either having the advantages of being a Preferred Stockholder, or being

treated as a Common Stockholder through conversion, consistent with the rights of the other Common Stockholders.

The term sheet will often provide for the payment of the cumulative preferred dividends in stock as

opposed to cash. If Common Stock is used to pay the cumulative preferred dividend, it would normally be valued at fair

market value and some formulation of how to calculate fair market value will need to be addressed. While the use of

Common Stock is the most common alternative for stock dividends, depending upon the goals of the parties, sometimes

the parties will decide to use Preferred Stock calculated at the issuance price instead. The Investor should consider the

tax consequences of structuring the dividend as a stock dividend.

The issue of who is entitled to determine whether the cumulative dividend is paid in cash or with stock is

also subject to negotiation. Both Investors and Companies prefer to be able to make that choice. In most cases, the

Company would choose to pay the dividend with cash if cash is available because the issuance of Common Stock will

dilute the founders’ position in the Company. However, if insufficient cash is available, the Company may be forced to

pay the dividend with stock. Depending upon the prospects of the Company, the Investors may find the payment of

cash most desirable (particularly in the context of a redemption), but in more favorable contexts may want to receive a

stock dividend under the belief that this will prove to be more valuable in the long run. This is particularly likely to be

the case in the context of a merger.

An Investor’s entitlement to receive a cumulative dividend can increase to very substantial levels over

time. When later rounds of financing are raised, the rights of earlier Investors to receive cumulative dividends are

frequently renegotiated.

Of the approaches presented, this version is the most favorable to the Company. This clause would be

used where the Series A Preferred Stock does not get any kind of a preferred dividend. This will allow the founders to

be paid a dividend on their Common Stock without first having to meet any prerequisites for the payment of preferred

dividends to the Investors. The Investors’ only right will be to participate with the holders of the Common Stock on any

dividends that are declared.

ABA Comments to NVCA Term Sheet - Final Version.DOC

Term Sheet Template - National Venture Capital Association Page 5

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