How to Approach Dividends and Conversion | VC Tim Draper

Dividends.

Okay, here, dividends. Okay, this says the holders of preferred shall be entitled to receive dividends at the rate of 8% per annum in preference to any dividend on common stock. So what really happens, this is really only there so that the government can say, oh, that's preferred stock and this is common stock. Because it says, when, if, as declared by the board of directors. Board of directors almost never, I don't say never, but almost never declares a dividend, and so this has never been a part of the thing. So it's not a big deal, but it's a way of keeping preferred and common separate. Sometimes it has happened, but— I've seen it. So that would mean that over there, if it were a year old and they declared the dividend of 8%, the investor would get $1,080,000, and then you'd end up with $920,000 in that case. Okay, liquidation preference. So this is the stack. This is how the stack works. This can be— this is a pretty short paragraph. This can be a really long paragraph if you've had multiple rounds of funding and different rounds have different priorities. Sometimes the A, B, and C are all pari passu, meaning that they're all on a fair basis, they will get their money at the same time, where D might be— preference to them, and E might be in preference to D and then to them. So it can be very complicated, but this is the stack and this is how the money kind of comes back out when you sell the business. Yeah? Is stack the same thing as liquidation preference, the same thing as seniority? Kind of. Seniority means my money comes out before your money, right? Preference means— seniority can include the debt and various rounds of preferred and the common, and it's who's senior. Turns out the people who are the most senior are trade creditors. They get the money out first, then the banks, then it goes down. And then what was the third— oh, preference.

Preference.

Preferences are just for preferred stock, but in concept you get it. Those are all kind of the same thing. The stack, or waterfall is another term for it, is how the money goes into the various pockets when a company gets bought. Yes, ma'am.

So you said that depending on the series round or the round that you're Will this term sheet stay and you'll just keep updating it according to each round of investing?

Yeah, this term sheet is good, but then the new term sheet dictates this one because there is a term at the end that says this supersedes all previous term sheets.

Okay, and so then you would take a lot of it from this one.

Yeah, this— right, exactly. This term sheet sets the precedent. For all your other term sheets, because investors are generally pretty lazy and they don't want to go in and change everything. Sometimes they, some of the East Coast guys bring their lawyers in and— but generally they don't want to mess with it. It's like, oh yeah, it's standard deal, whatever. Yeah.

So you said that most people or some people at least won't have a Good salary. I mean, startup, startup, or even I think Steve Jobs or Mark Zuckerberg had a very low salary.

Yeah.

So, and they don't give out dividends. How do they take their own money? How do they live? Yeah. And the money stays in the company forever. I mean, as stock, right?

They want to, but they want to keep it in there because they're shareholders.

But as a new startup, you need minimum amount of money, right?

You need to figure out how to pay yourself. enough to live and whatever. Yeah, yeah, that's important. Yes? Does preferred stock change its form as it's exchanged from person to person or throughout the lifecycle of a company, like when it becomes— when a company goes through an IPO or something like that? Yeah, I'll get to that, but I'll tell you right now, when it goes IPO, it's very rare that people are not forced to convert from preferred to common. It's usually a forced conversion. And this term sheet will show forced conversion. Some people, occasionally that term's not in there. And so once in a while you go to the New York Stock Exchange, sometimes they've got 2 listed prices. One's the preferred and one's the common.

Yeah.

So you mentioned the term sheet. So we've kind of gone through that. Okay, conversion. Okay, these are kind of odd, but anyway, the holders of the preferred will have the right to convert preferred shares at the option of the holder at any time into shares of common at an initial conversion rate of 1 to 1. The conversion rate shall be subject from time to time to anti-dilution adjustments as described above. So you have, If you're a preferred shareholder, you have a choice, common or preferred. Okay? So over here, in most of these cases, the preferred would want to be preferred. Every once in a while there's a situation where you would rather be common.

And—

One of those situations is the IPO. When it goes public, you want to be common because you want tradable shares. You don't want to be stuck with preferred shares that you can't trade. And the other thing is that as this is written, the preferred stock doesn't actually have the same rights as the common stock. And sometimes people have to convert some of their preferred to common in order to win a vote or something. So there are some weird things that happen, but— so that is here on conversion. And then automatic conversion, this is all preferred shares will be automatically converted into common stock upon the closing of an underwritten public offering, so that's your IPO, that values the company at least $50 million in an offering not less than $10 million. So what they're saying is it's got to be a big enough IPO or else you don't have to— you're not able to force conversion on us. And then it says before deduction of underwriting discounts and registration expenses. So the investment bankers put that piece in. Or approval of 50% of the Series A preferred. If I were not the only investor, if my $150,000 were split amongst 3 or 4 different people, and I had— and half of us, or a third of us wanted to keep it as preferred, but two-thirds of us wanted to convert it to common, the two-thirds would carry the day.

Smart.

Why would you want to keep it preferred during an IPO? You wouldn't, generally, except sometimes you want to keep the preference. Sometimes the preference might be worth more than the stock. There are situations where there's such a big preference stack that the common shares aren't really worth that much. But see, like, let's say $100 million has gone into the company. So the preferred stack has $100 million in it. And the company is valued at— the whole company is valued at $80 million. You'd want to keep your preferred because you'd at least get your money back.