A cumulative dividend on non-participating preferred, worked across exits: where it pays, where it is worth nothing, and the one clause that changes everything.
An accruing dividend compounds into the liquidation preference; it is not paid in cash. On a 60.0 growth investment at 8 per cent for five years the 1x preference becomes 88.16, which guarantees an 8.0 per cent IRR in any exit worth at least that much and lifts the exit value at which the investor converts from 240.0 to 352.6. Above that point the dividend is worth nothing, unless the accrued amount also converts into shares.
Worked in full in The Growth Equity Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Growth equity investors often take non-participating preferred with a cumulative dividend instead of a higher preference multiple or participation. The clause reads modestly, "8 per cent per annum, cumulative, compounding annually, payable on a liquidation event", and its value is concentrated in exactly the outcomes where a growth investment disappoints. Pricing it means running the waterfall at several exit values, not at the base case.
| Term | Value |
|---|---|
| Investment | 60.0 |
| Post-money valuation | 240.0 |
| Fully diluted ownership | 25.0% |
| Preference | 1x, non-participating |
| Accruing dividend | 8%, compounding annually |
| Exit | end of year 5 |
=Invest*(1+Rate)^Years.=MAX(MIN(Pref,E),Own*E).| Exit equity value | No dividend | MOIC / IRR | 8% accruing | MOIC / IRR | Taken from common |
|---|---|---|---|---|---|
| 150.0 | 60.00 | 1.00x / 0.0% | 88.16 | 1.47x / 8.0% | 28.16 |
| 240.0 | 60.00 | 1.00x / 0.0% | 88.16 | 1.47x / 8.0% | 28.16 |
| 300.0 | 75.00 | 1.25x / 4.6% | 88.16 | 1.47x / 8.0% | 13.16 |
| 400.0 | 100.00 | 1.67x / 10.8% | 100.00 | 1.67x / 10.8% | 0.00 |
| 1,000.0 | 250.00 | 4.17x / 33.0% | 250.00 | 4.17x / 33.0% | 0.00 |
The dividend turns a flat exit, a company sold for its entry valuation five years later, from a 1.00x into a 1.47x. It is worth the full 28.16 at every exit from 88.16 up to 240.0, less below 88.16, tapers to nothing between 240.0 and 352.64, and is irrelevant above. It is downside protection with an 8.0 per cent coupon, and it is paid entirely by the common shareholders: at 300.0, management and founders receive 211.84 instead of 225.00.
The accrual protects the IRR only while the company is worth at least 88.16. Below that the investor takes everything and still loses money; a cumulative dividend is not a security interest.
Three variations change the answer materially, and all three are common.
| Variant | Preference | Conversion point |
|---|---|---|
| No dividend | 60.00 | 240.0 |
| 8% simple, 5 years | 84.00 | 336.0 |
| 8% compounding, 5 years | 88.16 | 352.64 |
| 8% compounding, 3 years | 75.58 | 302.3 |
| 8% compounding, 7 years | 102.83 | 411.3 |
Time is the strongest lever. Every extra year of hold pushes the conversion point up, so the clause is worth most in the investments that take longest to exit, which are usually the ones that went sideways.
Some term sheets say the accrued dividend is payable "on conversion or liquidation, in cash or in shares at the original issue price". That is a different instrument. If the 28.16 of accrued dividend converts into shares at the entry price, the investor's 25.0 per cent stake grows to 32.88 per cent of the company, and the dividend now pays at every exit value, not only in the downside.
At a 400.0 exit the investor receives 131.50 instead of 100.00, 2.19x instead of 1.67x; at 1,000.0 it receives 328.76, a 40.5 per cent IRR instead of 33.0. A clause modelled as downside protection is in fact a ratchet on ownership. Read the conversion mechanics before the coupon, and model both legs of the waterfall as worked in when non-participating preferred converts.
The second mistake runs the other way: valuing the dividend as 8 per cent a year of return. In the base case of most growth underwriting, an exit at three or more times entry, it adds nothing. Its value is an option on failure, and it should be negotiated as such against the alternatives, a higher preference multiple or capped participation.
The other side of holding a growth position, what it costs to defend the stake through later rounds, is worked in the free companion workbook.
A cumulative dividend accrues every year whether or not it is declared and is owed before common shareholders get anything; a non-cumulative one lapses if not declared. In venture and growth deals the non-cumulative kind is rarely paid at all. An 8 per cent cumulative dividend on 60.0 adds 28.16 to the preference over five years.
The term sheet must say, and the difference grows with time. On 60.0 at 8 per cent over five years, simple accrual gives a preference of 84.00 and compounding gives 88.16. The conversion threshold moves from 336.0 to 352.64 of exit equity value. Read the wording: 'compounding annually' and 'cumulative' are not the same promise.
The common shareholders and management, and only in the exits below the conversion point. At a 300.0 exit the investor takes 88.16 instead of the 75.00 its 25 per cent would give, so common receives 211.84 instead of 225.00. Above 352.64 the investor converts and the accrual costs nobody anything.
This article is one calculation from The Growth Equity Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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