TL;DR - When reviewing a term sheet, founders should watch out for terms calling cumulative dividends and payment in kind dividends
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Tags - term sheet, term sheet pitfalls, cumulative dividends, payment in kind, venture capital
- What are some things that founders should watch out for in a term sheet?
- When reviewing a term sheet, founders should watch out for:
- Cumulative dividends
- Most dividends get paid out only if the board chooses to do so, but cumulative dividends are required payments, whether or not the company can afford them.
- In most cases, they are basically a way to sneak in an increase in the liquidation preference because investors know the company is not going to be able to pay the dividends until a liquidation event occurs.
- Should be avoided if possible.
- Payment in kind (PIK) dividends
- Typically combined with cumulative dividends.
- State that the required dividends will be paid out in company stock; instead of giving the investors a certain amount of cash every year, the company is obligated to give them a larger and larger equity stake - without them putting in any more money.
- Even VCs admit that cumulative PIK dividends are a dirty trick, so they should be avoided if possible.
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