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    Cumpref dividend: equity or debt?

    Private equity transactions are normally funded with a mix of equity and debt. The equity component consists for the largest part of cumulative preference shares with a certain coupon (say 10%). The coupon is a fixed dividend which accrues on an annual basis and which is paid out (together with the nominal amount and share premium paid on these preference shares) at exit.

    The question arises how these accruals are to be accounted for in the company’s financial statements. According to Dutch GAAP and IFRS, this should be booked as debt if the obligation to pay out is unconditional. However, in the event such obligation is not unconditional, these accruals must be booked as equity.

    Since the enactment of the Flex Law in October 2012, dividend resolutions of the general meeting are without any legal effect as long as the board has not approved the same. When deciding to approve or to disapprove, the board must determine whether thereafter the company is able to continue paying its due and outstanding obligations. This judgement call must be made at the moment of actual payment (i.e at exit) and not at the moment of annual accrual. This leads me to the conclusion that the cumulative preferred dividends on preference shares qualify as equity and not as debt, which was always the case before the Flex Law came into force. This conclusion also requires the lawyers and notaries to revisit their drafting of the relevant clauses in the shareholders agreement and the articles of association. It may also make the investors opt for a shareholders loan as the common alternative for preference shares.

    I wonder whether the players in this industry (PE investors, CFO's, financial, legal and tax advisors) have these consequences clearly on their radar. Interested to hear any thoughts on this.

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