While I am not familiar with their work and investments, I have to say I am impressed by the "Creed" of Lowercase Capital. They point out several key flaws in the venture capital industry and say they want to find ways to work around them, which is a step in the right direction. I recommend anyone interested in venture capital take a look:
For the last few weeks I have been discussing exit strategies as a means of getting capital to investors so that they can see a return on investment. While exits are the most likely way for an angel investor or venture capital/private equity fund to see a return on their investment, with longer term investors, including investors in publicly traded funds, a more common way for owners to receive capital from the company is through a dividend. Dividends have become, unfortunately, less common among publicly traded stocks in the last few decades. Where, once, an investor would buy shares in a company in order to receive their annual dividend as an income source, nowadays most investors in publicly traded stock only see a return on their investment when they sell it.
First, let’s talk about what a dividend is. The board of directors of a company can, at its discretion, elect to pay out a dividend to the shareholders of the company. The dividend can be in cash or in kind. In kind dividends are usually in the form of stock – frequently stock in the company or a subsidiary. Usually, the amount of the dividend is determined in aggregate – that is the total amount the company is going to pay out is determined. That amount is then distributed to shareholders on a pro rata basis (i.e. divided equally among the shareholders according to the number of shares they hold).
The main reason a venture backed company is unlikely to issue a dividend is relatively straightforward. Any money distributed to investors is capital that cannot be used by the company to grow the business. A fundamental assumption that is made when Venture Capital firms invest in a company is that the company is likely to grow rapidly, thus growing their money faster than they would be able to do elsewhere. Consequently, if the company keeps the money and uses it to grow the business, which should result in a greater return on investment than if the company distributes the capital out in order to be invested elsewhere.
From an accounting perspective, dividend distributions appear on the cash flow statement and in the statement of retained earnings, but do not reduce net income. On the balance sheet, a dividend distribution would affect retained earnings. Usually, the amount of a dividend distribution will not exceed the net income of the firm in that year.
While dividends are almost non-existent in venture-backed companies and increasingly uncommon among public companies, privately held companies without institutional investors often use dividends, particularly when all the shareholders are also employees of the company. One reason for this is that while the salary these shareholders receive as employees is taxed as ordinary income, dividends they receive as owners are taxed at a more favorable rate.
A particular situation to be aware of is the possibility of a dividend preference on preferred stock. If preferred shares have a dividend preference (usually expressed as a dollar amount per share), then if the company elects to pay a dividend that year, the dividend preference must be paid out first, prior to any common dividends. Dividend preferences may or may not accrue, depending on the specifics of the preferred stock. If the preference accrues, then any year in which a dividend is not paid is carried forward. Should the company elect to pay out a dividend in a future year, all the accrued preferred dividends must be paid out before the common dividend is paid.
Dividends, therefore, represent an important way to return capital to investors, even though there are a great many circumstances where it is not used. In addition to all the ways they are functionally important, discussed above, dividends also play an important role in valuation – a topic I intend to discuss in greater depth soon.
Disclaimer: None of the above is intended as legal advice. If you are seeking legal advice, please consult your attorney.
For the last few weeks I have been discussing exit strategies. Today, we will wrap up the topic by discussing company dissolution.
Generally, dissolution is not a strategy people plan to do, though there are exceptions. Funds, for instance, are intended to have a limited lifetime. At the end of that life, the fund is dissolved and any assets of the fund are distributed to the investors. Even if your company is not one that you create for a limited purpose and intend to dissolve, understanding company dissolution is important as it represents a “worst case scenario” for the firm.
When a corporation is dissolved, the first thing to occur is that all creditors are paid in full from the assets of the company (assuming the company does not need to be put through bankruptcy). The remaining assets of the company are then distributed to shareholders. Often, this involves liquidating the assets, but occasionally shareholders will accept in-kind distributions of assets.
If all the shareholders have common stock, then the distribution will be on a pro-rata basis determined by the percent of the company each shareholder owns. This distribution, however, can be dramatically affected by preferred shares. Some shareholders will have a preference guaranteeing them a particular amount upon dissolution. In that event, the preferred shareholders must have their preference paid out first. If the stock is participating preferred, then the preferred shares will be included in the distribution of any remaining assets after the preference is paid out. If they are not participating, then only the common shares will be used in the calculation of the asset distribution.
For example, suppose a company has three classes of shareholders. 80 shares of common stock are outstanding. 20 shares of participating preferred stock are outstanding containing an aggregate preference of $50 to be distributed to the shareholders. 10 shares of non-participating preferred stock are also outstanding, and these have an aggregate preference of $50 to be paid out as well. The company has $200 in assets at the time of dissolution.
First, the preferences would be paid out, $50 to the participating preferred shareholders and $50 to the non-participating preferred shareholders. This leaves $100 in assets in the company. This is then distributed among 80 common shares and 20 participating preferred shares on a pro rata basis, resulting in $1 per share to be distributed.
The main downside of company dissolution as an exit strategy is that the company no longer exists afterward. Such a strategy is, therefore, only a good choice if 1) necessary due to poor company performance or 2) if the company is created only for a limited purpose or project.
We are going to conclude the series on exit strategies here. Understand that there may be other strategies for you to pursue and that not every strategy will be available to your company. Knowing some of your options, however, will help you gauge how best to repay your investors. Next week we will discuss dividends as an alternative means of getting capital to your investors without having to exit the company.
Anyone looking to raise capital needs to understand how their potential investors work. To borrow a term from project management: you need to understand the stakeholders involved in the venture capital firm as well as how they are affected by investment in your company. We are going to use a Venture Capital fund in this article, but much of what is discussed is applicable to other forms of private equity investment.
Let’s talk first about structure. When an entrepreneur looks to raise capital, they usually think of the investor as a venture capital fund, end of story. Within the abstract idea of “venture capital fund,” however, are generally three distinct entities. First, is the Fund Manager. The fund manager is what is typically thought of as the Venture Capital Firm. Draper Fisher Jurvetson (DFJ), for example, is a fund manager. The fund manager makes the investment decisions and is the group you interact with when you are trying to raise capital.
The second entity is the fund itself. When DFJ invests in a company, the fund manager does not us its own capital or own the stock in the company. The fund managers create separate companies (often limited partnerships) that hold the capital that is invested and any stock in the portfolio companies. Consider this article that discusses how DFJ earlier this year raised its tenth technology fund. That means DFJ created a separate company and raised money from investors that this separate entity, called the Fund, holds. When DFJ finds a company it wants to invest in, it invests the Fund’s money and the Fund in return receives the equity.
The third group is the limited partners. These are the investors who put money into the Fund. The fund manager is the general partner of the Fund, and thus the one responsible for running it and liable for any wrongdoing, but these other individuals maintain an ownership interest in the Fund.
As you can see, there are two types of stakeholders in the Fund, the general partner and the limited partners. Each of these stakeholders benefits from the success of the fund, but how that plays out can be very different for each.
The next thing you should understand is the Fund lifecycle. Typically, a venture capital fund exists for only 10 years (with the possibility of an extension of one or two years to allow for liquidating the portfolio company stock). At the beginning of the Fund’s life, the fund manager identifies the Limited Partners and receives their investments into the newly created fund. These Limited Partners will not be able to control their invested capital, or realize a return on their investment, until the 10 year lifetime is over. At the end of 10 years, the Fund is dissolved and the capital it holds is distributed out to the partners. That means that any stock purchased by the fund (the investments it makes) must be sold prior to the Fund’s dissolution. Since a typical investment in a startup venture can be expected to last 3-5 years, you can see that there is a limited window of time in which the fund manager can choose to invest the Fund’s capital. This situation, combined with the weak economy, has led to some serious problems for the Venture Capital Industry, as discussed in this Wall Street Journal article.
Finally, it is important to understand how the stakeholders actually make money from the Fund’s investments. The Limited Partners are easily understood, at the end of the Fund’s life, the Fund is liquidated and they receive a distribution from that amount. The fund manager, however, is compensated somewhat differently. Fund managers are compensated in a manner similar to hedge funds, an arrangement called “2 and 20.” While the exact numbers vary slightly (sometimes it may be 1 and 20 or 3 and 20), the concept works as follows. Each year, the fund manager receives compensation in the form of 2% of the net asset value of the Fund. Thus, if the Fund’s net asset value is $100m, the fund manager receives $2m that year, regardless of how well or poorly the Fund’s investments are doing. In addition, the fund manager receives a performance fee of 20% of the return. For example, if the Fund starts out at a value of $100m when it is created and 10 years later has a value of $600m, the return would be $500m and the fund manager would make 20% of that ($100m). The remainder, ($400m plus the original $100m) would then be the amount distributed out to the Limited Partners.
Understanding this is important for several reasons. First, knowing how far into the life cycle of the Fund you are will give you an idea of how soon the investor expects you to have an exit. Second, when you are trying to determine if you can generate a substantial enough return on investment for a venture capital fund, remember to take into account not only that many of the other portfolio companies will fail (and if you are the one-in-ten big success you will have to make up for their failures), but also deduct the fund manager’s fees from the amount that will actual be returned to investors.
There is a great video available of David Heinemeier Hansson's speech at Stanford. I highly recommend anyone considering going back to school for an MBA just to start a company take a look at it. For those not familiar with Hansson, he is the Danish programmer responsible for creating Ruby on Rails.