Round Two of Negotiations with the VCs

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Another Monday and another meeting with Kate, Daniel and Susan, the representatives of Venture Funds, Inc. (VFI).  This time we are meeting at their offices to continue discussions about a VFI investment in Best Blogs Ever, Inc. (BBE).  At the end of our last meeting with the venture capitalists, everyone had agreed that they would purchase a minority interest in BBE's common stock.  They would invest the balance of the needed $70,000 in BBE by purchasing its new issue of preferred stock.

The discussion quickly became focused on the rights the preferred stock would have in exchange for not having a vote.  Daniel said that preferred stock receives a fixed dividend that the company would be required to pay annually.  That would make the preferred stock dividend much like a loan payment to a bank.  Mary Jo, our financial consultant, indicated that the earnings of BBE were not steady.  They fluctuated yearly.  What should happen if there were not enough earnings in a year to pay any dividend?  The board of directors of BBE had to have the discretion not to declare a dividend.  They had to have the ability to pass on the dividend for the preferred and the common stock in a year in which BBE had either poor earnings or a loss.  Our treasurer proposed that the preferred stock dividend would have to be paid before any dividend could be declared by the board of directors for the common shares.  This is a fairly common right granted to preferred stock holders.

It was agreed that the directors of BBE would have the right not declare any dividends; however, there would be a cumulative dividend provision in the Articles of Incorporation.  If a company has cumulative preferred stock, then any and all unpaid dividends on the preferred shares must be repaid before the common shares could receive any dividends.  Kate suggested that if the company was unable to pay the preferred stock dividend for a number of years, this would be an indication that the company was not being run properly.  In that case, VFI should have a right to take control of the company and install a new board of directors.  The new board could elect new officers to manage the company.  New managers might be able to increase earnings and restore the dividend.  Since VFI had agreed to buy a minority of the common stock so the original shareholders could maintain control, it would need to gain more common shares in order to outvote the original shareholders.

Susan said that a way to provide VFI with additional shares of common stock would be to add a convertibility provision to the Articles.  If the preferred stock dividend was not paid for a number of consecutive years, then VFI would have the right to convert some or all of its preferred shares into common shares with voting rights.  Preferred shares with that type of right are called convertible preferred shares.  The convertibility provision would set forth how and when the preferred shares could be converted.  She also pointed out that if BBE were to be sold to another company or group of investors, VFI's preferred shares would not share in any increase in the value of the company.  Preferred shares do not appreciate in value.  Their value remains at the original purchase price, and the owners receive their investment back if the shares are redeemed.  She proposed that the VFI's preferred shares should also be convertible into common shares if the shareholders voted to sell BBE or take it public at some point in the future.  By converting the preferred shares into common, VFI would share in any increase in the value of BBE and any consequent appreciation in the common shares.

The parties agree to meet again next Monday.  This will give each side the opportunity to consider the issues raised in today's discussions.

If there is any financial term you would like explained, please submit it in a comment and I will try to answer your question.

Comments are always welcome and are posted within 24 hours of receipt.