Adding dividend and buy back (redemption) provisions to equity investments allow private companies to offer investors payback options that don’t necessitate a sale or IPO. Public companies commonly offer dividends and redemptions. Private venture-backed companies, on the other hand, rarely do because they are usually seeking to maximize revenue and customer growth in anticipation of a sale or IPO.
We have seen entrepreneurs and investors take the traditional tools of dividends and redemptions and use them in new and innovative ways in the early-stage context. Here are three of the core innovations:
Variable Payment Dividends
Mandatory dividend payments are based on an agreed-upon measure of the company’s financial performance, such as revenue, EBITDA, or cash flow. The term sheet specifies how the performance metric will be defined and payments calculated. We have seen target returns of 2-4x over 5-7 year periods with variable payment dividends. The parties may choose to defer initial dividend payments for an agreed period of time, and payments could be subject to a cap. If the parties, however, desire to limit investor participation in a change of control (i.e. sale, merger or IPO), they will need to consider IRS rules that could lead to potentially unfavorable tax treatment. See Section 305 Rules.
Variable Payment Redemptions
Periodic redemptions are mandatory, but the number or percentage of shares redeemed (and therefore the amount of the redemption payment) varies based on an agreed upon-measure of the company’s financial performance. We have seen variable payment redemptions used by investors to create shorter term liquidity for a certain portion of their investment, while keeping the remaining equity at risk. The investors then look to either conventional exits or post-investment negotiated buyouts to achieve liquidity on the portion that is not mandatorily redeemed. Investors will want to carefully consider potentially unfavorable tax treatment that could result from these structures. See Section 305 Rules.
One-time redemptions after an agreed-upon time period can be used as the primary source of liquidity or as a secondary mechanism in case a sale or IPO does not occur within an expected timeframe. These redemptions are usually structured as optional rights for investors. Recognizing that large investor payments could negatively affect cash flow, we have seen experimentation around different ways to determine the amount of the payout as well as careful consideration of the mechanics and timing of payment. Payments, for example, are often extended for a period of 2-3 years after the investor exercises the redemption right. Investors will want to carefully consider potentially unfavorable tax treatment that could result from these structures. See Section 305 Rules. See Sample term sheet: impact equity earnback and this Case study of a lump sum redemption option for an emerging market mobile tech company for examples of terms for one-time redemptions.
Both dividends and redemptions can be offered in a single investment. Variable payment dividends, for example, can be used to return cash to investors over the lifetime of an investment, with a final redemption payment used to terminate the investment.
Variable payment dividends
The parties can agree to variable dividend payments that are based on an agreed-upon measure of the company’s financial performance, such as revenue, EBITDA, or cash flow. The term sheet specifies how the performance metric will be defined and the payments calculated. Learn more about variable payment dividends.
Cap on variable payment dividends
The parties could agree to a cap on the amount of variable payment dividends. Learn more about adding a cap on variable payment dividends.
Variable payment redemptions
With variable payment redemptions, the investor stock is redeemed in installments, with the number of shares redeemed in each installment based on an agreed-upon measure of financial performance. Learn more about variable payment redemptions.
Redemption repayment amounts
There are number of ways to set redemption prices, each with different economic and tax implications for both the company and its investors. Learn more about redemption repayment amounts.
Initial dividend payment timing
If the parties want to defer initial dividend payments, they will need to agree whether the payment obligations will be assessed or “accrue” during the deferral period or if payment of those amounts will be waived (no accrual). Learn more about initial dividend payment timing.
How one-time redemptions are triggered
For one-time redemptions, the parties will need to agree when the redemption occurs, and whether the redemption will occur automatically, at the election of the investors, or at the option of the company. Learn more about how one-time redemptions are triggered.
Installment payments for one-time redemptions
The parties can elect for a single redemption trigger, but agree that the payments may be made over an agreed upon period of time. Learn more about installment payments for one-time redemptions.