Equity Investment - what dividend entitlements to expect

In any situation where investors are making an equity investment, it is normal to reach an agreement as to what the relevant parties expect to receive by way of dividends on their investment. This article is a very brief overview of some of the relevant issues.

The most fundamental rule in relation to dividends is that they can only be paid out of distributable profits. In general terms distributable profits are the company's accumulated realised profits less its accumulated realised losses (as shown in the accounts). This is the crucial distinction between dividends on shares and interest on loans - interest does not need to be paid out distributable profits.

Needless to say, a debate about dividend entitlements might be regarded as entirely theoretical in the context of the many technology start ups where the business plan does not contemplate profits for many years. That said, it is preferable to reach agreement as to what dividends can and cannot be paid at the outset. Furthermore, it is the case that many technology businesses are capable of generating profits from a very early stage.

Some equity investors will require a preferential right to dividends. This is normally achieved by their subscribing for a different class of shares from the management team. These shares would either have a right to a fixed dividend (eg Xp per share per annum) and/or a participating dividend (a fixed percentage of the company's profits). In all cases, there must be distributable reserves to pay the dividend but the investors rather than the management would have the first bite of the cake. Once any preferential dividends have been paid in full, the balance can either be shared between the management and the investors as if they all held the same class of shares, or there can be some type of "catch up" dividend for the managers allowing them to receive an equivalent dividend to that received by the investors, before the investors receive any further payment.

If the deal is simply that dividends will be shared pro rata to shareholdings between equity investors and management, then the provisions relating to dividends in the investment documentation will be very straightforward.

It would be normal to provide that any dividends other than those expressly contemplated in the investment documentation up front can only be paid if the equity investors agree. If no specific dividends are agreed, it is also quite common to set out a dividend policy up front - in other words, to agree in broad terms how much of the company's profits the shareholders expect to receive by way of dividend and how much should be re-invested in the company.

One final point to note is that, as an incentive to management to achieve exit within the timeframe agreed at the outset, it is becoming increasingly common for any fixed or participating dividend on the investors' shares to ramp up significantly if the exit is not achieved in that timeframe.

If you would like further information, please contact corporate partner David Day by e-mail at [email protected] or by telephone on +44 (0)20 7367 3000.