In my post, Dividends:  Common Structures, I talk about the three commonly used structures by which VCs accrue dividends.  The motivation behind each dividend structure varies. 

When Declared
The when declared structure is designed to ensure that the VCs aren't excluded from dividend payments.  This prevents the board from declaring dividends that only pay other share classes and leave the VCs out.

Cumulative
Cumulative dividends enable VCs to be compensated for investments that take longer to liquidate.  From an investor perspective this makes sense as the longer it takes to realize an investment (have the company exit) the worse their returns looks to the investors in the venture capital fund.  As a result, by accruing dividends a VC's return can be enhanced partially offsetting the effect of having a longer duration to liquidation.

Compounding
Compounding dividends can substantially increase investor returns over time.  While some VCs will use this structure simply to enhance returns, this approach may also be used to create incentive alignment.  In unique situations where there is either 1) additional risk to holding onto an investment for an extended period (e.g., a patent expiring) or 2) where the is concern that the entrepreneur will not be seeking an appropriately timed exit. 

In the situation of the patent expiration, the value of the exit may decline over time.  Having compounding dividends enables an investor to increase their liquidity preference thereby increasing the percentage of the exit value that they will have rights to as the company's value declines.  This may have the effect of stabilizing a return.  Conversely, in this scenario the operators will receive a smaller percentage of the payout as time passes creating an incentive from them to sell the company early.

In the second situation, where the investors are concerned about the entrepreneur's intent to pursue an exit, the compounding dividends does create an incentive for the entrepreneur to consider the timing of the sale (in addition to the size of the exit).

It's worth noting that it's most common to see the when declared or cumulative dividend structures in term sheets.

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Term sheets may include some provision for dividends to be "paid" to the investor.  These dividends are commonly structured in one of three ways:  when declared, cumulative and compound.

When Declared
In this structure investors only get dividends when the board declares a dividend for the firm.  The legal language will often ensure that a dividend cannot be paid to another share class without also paying the same dividend to the preferred shareholders (investors).  To be clear, if the board doesn't declare a dividend, then one isn't paid.  If the board does declares a dividend, the investors get to participate.

Cumulative
Another common structure is for the investor to require that an annual dividend be paid to them.  Usually the dividend amount is a percentage of their initial investment. 

Most early-stage companies do not have excess cash to pay dividends, however.  If they do generate excess cash they typically re-invest it into the company.  As a result, investors accumulate their dividends as liquidity preference, to be paid before common shareholders get to participate. 

Compounding
Compounding dividends are structured much like cumulative dividends.  They are paid based on a predetermined percentage and accumulate as liquidity preference.  Compounding dividends differ in that the annual dividend amount is not determined as a percentage of initial investment, it is determined as a percentage of the initial investment plus the total accrued dividends.  Investors are paid dividends on dividends.

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Tomorrow is the anniversary of America's independence - a great time to be thinking about how to be a better citizen both at home and globally.

With that spirit in mind, as of yesterday this blog has become internationalized.  I added (per the recommendation of my rock star intern Wayne) Google translator.  If you don't read English well, fear not - you can now read this blog in dozens of languages.  Hopefully this content will be able to help entrepreneurs everywhere.

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In my post, Don't Let Your Board Get Too Crowded, I made the point that large boards can become cumbersome - early stage firms generally should limit the board to 5 to 7 directors. 

There are, however, situations where there are more than 7 people who feel entitled to having a seat on the board.  This might arise when there are numerous founders, angels or VCs involved with the company. 

When this happens you will need to help your constituents negotiate against this constraint.  One way to keep some of the involved parties engaged without giving them a board seat is to give them observer rights.  Board observers are entitled to attend meetings and participate in the group's leadership, even though they don't have a formal vote on the board.

Board observer rights are also often requested by VCs when boards are not already over crowded.  This right enables them to bring junior members of their team to the meetings to give the junior staff more experience and provide more support for the company.

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While identifying prospective independent board members will help make VCs slightly more comfortable investing in your startup, they may still be concerned about getting an independent approved.

Selecting independent board members is often done by a process of mutual approval, whereby both the directors representing the management team and the investors must approve them.  This selection process is designed in spirit to ensure that the independent director does not favor one side or the other (they should remain independent of the influences of either party).  Nobody wants the other side to have a ringer. 

Since independents must receive mutual approval be to be accepted, VCs are sometimes concerned that the management representation on the board will choose to block all of the proposed independents leaving the company with an even number of directors and no mechanisms for breaking ties in the future.  While this doesn't happen if all parties are acting in good faith, being a good partner is not always a high priority for individuals. 

As a result, VCs may seek to insert penalties in the term sheet that incentivize the management side of the board to select an independent director.  These terms might include something as aggressive as the VCs taking control of the independent's board seat after a designated period of time until an independent is selected.

In sum, it's important to VCs that your company selects an independent board members.  Typically this comes about through a good faith effort by all of the parties.  VCs that have had problems securing an independent director in the past, may look for mechanisms to ensure that the management team actively works to find and approve this person.

It can sometimes be more challenging then expected to secure an independent board member.   This is an important issue for investors since if an independent is not selected the board can be positioned for deadlock if there are contentious issues in the future. 

There are two steps in securing an independent board member - identifying interested candidates and then approving them.  It's important to think about these two steps when you are navigating the fundraising process.

Identifying independent board members is sometimes easy and sometimes not.  Independent directors are motivated to join the boards of startups for a variety of reasons.  Often they simply want to stay in the game (if they have retired) or they simply want to further their credentials and credibility in a specific industry.  The more the prospective board members are focused on the latter (building their domain expertise and credibility), the more they're going to need to believe in the prospects of the company.  The younger your company the more vision the prospective board member will need to have in order to get excited enough to join the venture. 

A good management team pursuing a great idea that is backed by credible investors generally should appeal to potential independents.  Despite that, there are times when startups with the right profile have a difficult time identifying interested independents.  Often this happens when the company is still very early in its development and has yet to demonstrate traction or when there are few people who have the required expertise to join the board, reducing the odds of finding a match. 

As a result, it is worthwhile to think about potential independent board members early on in the fundraising process.  Having some ideas about who might join the board helps take another small bit of friction out of building the company, making it slightly easier for investors to get comfortable.