Preferred Stock Dividends

Dividends can create legal issues for start-up businesses in a number of ways. First and foremost, venture-backed, start-up entities generally do not throw off a lot of cash. Consequently, dividends are rarely declared by start-up boards. To the extent the company is generating cash, it is typically reinvested in the business rather than turned back to investors. 

Some preferred investors will negotiate for dividend rights, either mandatory or contingent on the board declaring dividends, as part of their series investment.  Where preferred investors have negotiated such dividend rights, these rights effectively put a clock on managers of the firm as they will be added to the return required by series investors and eat into any return for common shareholders on an exit event. 

Preferred shares have no inherent preferences or rights. They have only those preferences that are stipulated in the certificate of incorporation. In the cases that follow, plaintiff stockholders assert that its preferred shares have an inherent right to receive dividends notwithstanding the fact that no such right exists in the corporation's certificate of incorporation. Courts disagree with this argument. Remember, preferred stock get only those rights and preferences that preferred stockholders have negotiated for. There are not rights or preferences inherent to being a preferred stockholder.

Finally, when a board declares dividends the board must ensure not to run afoul of corporate law restrictions on declaration of dividends when the company is not solvent. In most businesses, this is not generally a problem. However, in cash-starved start-up entities, directors must be more cognizant of the potential legal risks inherent in declaring dividends that might be beneficial to series investors at the expense of the corporation