http://lowercasellc.com/creed/

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.



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. 



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.

Source: Veer Away from Heavy Management Theory (http://ecorner.stanford.edu/authorMaterialInfo.html?mid=2352)

In a buy-out, a group (in many cases the management of the company) buys the stock of the company from some or all of the existing shareholders.  Usually, when management purchases stock in the company (often through the exercise of stock options), the stock is newly issued.  In those instances, the transaction is a financing transaction, with the proceeds invested in the company.  In a buy-out, however, the company does not necessarily receive a capital infusion.  Buy-outs often take the form of a leveraged buy-out, meaning that the money used to buy the stock has been borrowed by the new owners, rather than the owners using their savings.  In addition to management teams, leveraged buy-outs are frequently used by Private Equity Funds when purchasing portfolio companies (a topic that will be discussed in another post).

In a buy-back, by comparison, the stock is purchased by the company itself, often using funds retained by the company in its bank account.  Buy-backs usually only repurchase a small portion of the outstanding shares of the company, but in some occasions (usually where one owner controls the majority of shares in the company and is operating the company) can be used to repurchase a large number of shares and consolidate ownership.  When sophisticated investors are involved, buy-backs sometimes occur as a result of a contractual obligation to repurchase the shares at a certain, specified rate if the company is not likely to have an alternative, favorable exit strategy.  This is one way investors may guarantee a minimum return on their investment.  Buy-backs may also contractually occur upon the death of a founder.  Founders, not wishing to have large portions of the company’s stock pass to third parties upon the death of one of the other founders, often include buy-back provisions that are triggered upon a founder’s death.    As may be evident, buy-backs are generally preferred as a method for exercising control over who retains ownership than as an exit strategy.

While in many ways the two strategies are more different than similar, I have opted to group them together because when creating a business plan, they are both among the least planned-for and desirable of exit strategies to include.  Buy-backs tend to be frowned upon for a number of reasons.  First, they often result in the  lowest return on investment to the investors, as compared with a strategic acquisition or an IPO.  Second, it means the founders (or shareholders seeking the current round of investment) view the new shareholders as only temporary partners whom they hope to buy-out as soon as possible.  Third, if a company is planning a buy-back, it usually signals that management does not actually know what to do with any excess capital the company generates in order to grow the company in the future.  If a company is building up substantial capital reserves and not using that cash to grow the business, investors usually take that as a sign that either the company cannot grow anymore or that management doesn’t know how to do so.  Either way, it indicates a significant shortcoming that investors view with disfavor.

By comparison, buy-outs are rarely included in business planning due to more practical considerations than the negative connotations.  While, similar to a buy-back, planning for a buy-out sends a message that the investors are only intended to be for a short term, the other buy-back fears tend not to apply.  However, unlike an acquisition, buy-outs are usually performed by management of the company or a financial investor.  Management usually only buys-out the company if the management team believes that the company is being run poorly and that by taking control of the company they can improve operations.  Such a problem is never a goal set forth in a plan as an exit strategy.  Planning for a purchase by a financial investor (i.e. a private equity fund) is equally difficult.  These investors often look for distressed or undervalued companies, focusing the current financial performance of the company and the possibility of improving that performance.  Again, investors tend not to look favorably on a company planning to be undervalued in the future. 

Planning for one of these strategies, however, may be appropriate in certain limited instances.  First, including the possibility of a buy-back or buy-out in the event that the company does not do an IPO or get acquired can indicate to potential investors that management has a back-up plan for allowing investors to realize their return.  Second, if potential investors are primarily friends and family of the company’s founders, those friends will likely not look negatively upon such an exit and the founders will be able to retain, or regain, control of their company at that time. 

It is important to remember that a buy-out, in particular, is not a bad exit strategy, but it is rarely one that is appropriate to plan for far in advance.  When the time comes to execute on an exit strategy, both a buy-out and a buy-back should be considered as serious options.  However, when looking three to five years ahead, a focus on one of these two strategies is likely to send the wrong signal to potential current investors – namely that the company will not be operating optimally when the time comes to exit.

Next week, we will take a look at one of the least popular exit strategies: company dissolution.

Related: Exit Strategies - Introduction (http://www.makariusconsulting.com/blog/2010/7/19/exit-strategies.html)
Related: Exit Strategies - Initial Public Offering (http://www.makariusconsulting.com/blog/2010/7/26/exit-strategies-the-initial-public-offering.html)
Related: Exit Strategies - Mergers & Acquisitions (http://www.makariusconsulting.com/blog/2010/8/2/exit-strategies-mergers-acquisitions.html)

Let us start out by defining what mergers and acquisitions are.  A merger is a method of combining two companies that is created by statute.  Only one of the two companies remains (in name) after the merger.  Statutory mergers are very specific types of transactions that, from a tax perspective, are treated differently from acquisitions. 

Acquisitions can broadly be put into two categories: asset sales and stock sales.  In an asset sale, the company chooses to sell all the assets of the company to the acquirer in exchange for cash or stock in the acquirer.  Asset sales are very common and are often the favored type of transaction for private company acquisitions.  A stock sale, by comparison, occurs when the owners of the acquired company sell their shares in that company to the acquirer. 

There are also many complicated acquisition structures that can be used, but most are based off these three broad types of M&A transaction.  The decision as to how the transaction will occur will be based on a number of business factors (e.g. an asset sale may result in invalidating key contracts or licenses since those contracts were with the original corporate entity and may not be transferrable).  Often, however, the most important factor in determining structure of the acquisition will be tax considerations.  Based on how the transaction is structured, the tax implications can dramatically alter how much the acquirer would have to pay or the seller would actually receive.

Selling a company can be a very quick and painless process or, more often, a long process.  If the seller is large enough, an investment banker may be retained to assist in the process.  This is most often the case when the company wishes to be shopped around.  If, by comparison, the company is approached by an acquirer without seeking to sell itself, or if the company is relatively small, bankers are less likely to be involved.  Both parties, however, will have accountants and attorneys advising them.  Either party may retain a financial advisor who is neither an investment banker or an accountant to help them negotiate valuation or other financial terms.  An appraiser or certified valuation expert may be retained as well to assist in that process. 

If there is competitive bidding, the board will consider a variety of offers.  The board will eventually begin negotiating with a single bidder, the results of the negotiation being put to the shareholders as a proposal. 

There are several great advantages to acquisitions as an exit strategy.  First, the purchaser frequently has additional resources that can be used by the company to help it grow more rapidly.  Second, sharing of administrative and other costs can reduce operating expenses.  Third, an acquirer usually only purchases a company if they see a way in which they can make that company even more successful than it currently is – rarely is a company purchased in order to continue operating at current levels.  This means increased attention from management to possible growth initiatives.  Fourth, the acquisition, if it is for cash, can result in cash immediately being paid to the shareholders.  With an IPO, for example, existing shareholders are often restricted from selling their shares on the open market for several months. 

There are several disadvantages to acquisitions that should be remembered.  First, the new owners may have a very different idea of the direction for the company.  This can result in employee layoffs, major strategic changes that are not in line with current employee expectations, or, in extreme cases, the breakup and sale of the pieces of the company.  While it is relatively uncommon these days, companies have been bought simply because of the value of the company’s assets.  The company may then be shut down while the assets are sold off or used by the new parent company.  A second issue is one of valuation.  Depending on the acquirer, valuations can be very disparate, and almost always less than an IPO.  If the acquirer, for instance, is a private equity fund, the valuation will likely be lower than if it is a strategic acquirer.  Strategic buyers tend to pay more than financial buyers because strategic buyers can expect to make more money due to the economies of scale and other advantages from integrating the businesses.  Third, a new set of owners could signal a very different direction for the business, one which management may not be happy with.  If the founders are still in management roles, it may be difficult to accept that now, as they are no longer the primary shareholders, their vision for the company may not be the one controlling the company’s direction.

Next week, we will take a look at the buy-out and buy-back as possible exit strategies.

Related: Exit Strategies - Introduction (http://www.makariusconsulting.com/blog/2010/7/19/exit-strategies.html)
Related: Exit Strategies - IPO (http://www.makariusconsulting.com/blog/2010/7/26/exit-strategies-the-initial-public-offering.html)

At its simplest, an IPO occurs when a corporation offers new shares of the company’s stock for sale on a public market for the first time.  The market could be the New York Stock Exchange, NASDAQ, or a number of others.  A somewhat simplified explanation of the process follows. 

First, the corporation retains an investment banker.  The company amends its articles of incorporation to allow for the new stock that is to be issued and makes any additional amendments to incorporating documents and bylaws that are required.  A respected accounting firm is retained to provide audited financial statements that completely comply with GAAP.  The investment bank will lead much of the process, which will include determination of an appropriate price for the shares, a “road show” where the management team travels to major markets to meet with institutional investors who are likely to become the main purchasers of the publicly sold securities.  One important thing to be aware of is that investors in the company prior to the IPO will likely have restrictions on their shares that prohibit selling them for a limited period of time after the public offering. 

Historically, the IPO was the most popular exit strategy for technology startups.  In the 1990’s, IPOs were occasionally performed with companies that had little revenue and no profits, most famously with the company Netscape.  Nowadays, public offerings prior to profitability or at least several million dollars in revenue is a rarity.  In addition, IPOs are far less common as an exit strategy than they once were.  In 1999, for instance, there were 541 IPOs.  By comparison, in 2009 there were only 63 and the largest number of IPOs since 2001 was 2007 with only 282.

There are several advantages to an IPO that make it attractive to investors.  First and foremost is liquidity.  Once a company is publicly traded, shareholders can sell their shares at any time on the open market.  Privately held shares can only be sold to specific investors and are often difficult to sell.  Second, an IPO can raise a substantial amount of capital for the company.  Third, it establishes an easy to assess value for the company.  Whereas the value of privately held stock is set based on the expectations and understanding of a handful of individual investors and is only set periodically when the company raises new capital, sale on the open market allows for a constantly updated valuation that is based on free market economics and not the assessment of only a few investors.  Finally, being publicly traded is an excellent “validator” for business transactions.  Due to the wealth of publicly available information on publicly traded firms, the trust placed in the firm by many shareholders, and the ability of the firm to navigate the regulatory hurdles that come with being publicly held, there is often a perception that publicly held firms are more reliable or stable than private ones.  This perception can help to close significant business transactions.

There are, however, some important disadvantages to an IPO.  The best known of these is the significant work and expense associated with being public.  Not only is the process of performing the IPO expensive and time consuming, but the time and money that is expended annually to remain compliant with securities regulations is large.  It is not uncommon for public companies to expend millions of dollars each year on compliance alone.  Second, while having thousands or millions of shareholders means that you can raise capital from sources not previously available to you, it means giving a say to each of those shareholders.  Performing investor relations and having to make certain (albeit limited) resources available to shareholders can be burdensome.  Next, the disclosure requirements of being a public company are available to competitors as well as your own shareholders.  Many managers are bothered by the idea of their competitors knowing how much they sell each year and through which divisions.  Finally, the burden on the managers and board of directors becomes even greater.  Where in a closely-held corporation rules can be somewhat flexible – permitting self dealing or holding only infrequent board/shareholder meetings and then by phone for example – once the company is public these duties must be performed in specific ways and done so with a degree of precision.

Next week, we will take a look at the merger or acquisition as an exit strategy.

Related: Exit Strategies Part 1 - Introduction (http://www.makariusconsulting.com/blog/2010/7/19/exit-strategies.html)

In the coming weeks, I will post about some of the most common types of exit strategies and discuss what they are and some of the advantages & disadvantages of each.  For those not familiar with the concept, however, I want to discuss what one is in this post.  The vast majority of companies are privately held companies.  While there are advantages to this (e.g. not having to make regular filings with the SEC, ability to use unaudited financial information), there is a major disadvantage in that stock in the company is relatively illiquid.  Being illiquid means that the stock cannot easily be converted to cash.  First, there are often restrictions placed on the stock around its sale in any shareholders agreements.  Even if none exist, finding purchasers for stock in closely held corporations is not easy, and while it has become easier in recent years with the growth of secondary markets, in order to remain in compliance with securities regulations there are limits on who it can be sold to and the restrictions will mean that the stock is frequently sold at a discount to what it would otherwise be valued at. 

An exit strategy is the solution to this problem.  It lays out how the board and management intend to give equity investors an opportunity to sell their equity and realize the gains on their investment.  Exit strategies can take many forms including public offerings, sale to a large acquirer, and a stock buy-back.  As equity holders in the company, it also represents how the founders can hope to see a return on their investment, other than paying themselves as employees.  If you intend to run a small, lifestyle business, having an exit strategy may seem less important, but it plays an important role as it is directly tied to your succession planning. 

Next week, we will start discussing the first of several types of exit strategy, the Initial Public Offering.

The first method for profiting is an investment whose goal is to receive distributions over an extended period of time.  The majority of investments that are done in anticipation of the company paying out dividends are friends and family investments. Rarely do funds or companies invest in a business in hopes that it will steadily distribute portions of its profits to the company.

The second method for profiting is through a “strategic investment.” Strategic investors are usually large established companies who see a way to improve the performance of their existing business by owning a part or all of your company.  This could mean that the investor sees synergies between their existing businesses and yours or this could mean that they want to enter your industry or geographic market and believe that acquiring or investing in your company will enable them to do so.  Strategic investors usually are looking to take a controlling stake in the company (if not purchase the company outright) because they need control over your company in order to ensure those strategic benefits.  A major advantage to a strategic investor/acquirer is that they usually will pay substantially more for your business than a purely financial investor would.  Another key advantage is that strategic advisors tend to bring more resources to the table that your business can use in the future, though some funds attempt to provide similar assistance through portfolio companies.

The third method is to bet on a company’s rapid growth.  Venture capital firms are famous for using this method of returning a profit.  Because the stock of privately held companies cannot be readily traded (though some secondary markets do exist for it) it can be difficult for investors in your company to sell their stock.  This has the added effect of increasing the risk of an investment since owning 50% of something that people claim is worth a billion dollars isn’t particularly valuable if nobody can buy it.  Most funds, therefore, rely on the idea of an exit strategy – a plan the company has in place that will enable investors to sell their investment in the future.  Typical exit strategies include acquisition by a large company or initial public offering.  These investors expect to see large sales growth over a short period of time since they usually only have 10 years in which to generate a substantial return for their investors. 

The fourth method is to use leverage to improve your financial return.  This is a widely used method of private equity funds that do not specifically target young, entrepreneurial ventures.  The easiest way to explain how this works is with a simple example.  A private equity fund buys 100% of the stock in a company at a value of $10 million.  The fund uses only $2m of its funds, borrowing $8m to cover the difference from a bank.  It uses the assets of the company it is investing in as collateral for the loan, so if the loan cannot be repaid, the bank goes after the company’s assets first.  The fund holds the company for several years, during which time the value of the company has grown to $12m and $4m of the loan principle has been repaid using cash flows generated by the company.  The fund then sells the company, receiving $12m in cash.  It uses $4m to pay off the remainder of the loan, netting the fund $8m in cash.  The company has realized a 4x return on its investment over a short period of time.

Understanding how potential investors intend to see a return on their investment can be a great advantage in investment negotiations.  If you know your investor is looking to use leverage to improve their return, positioning your company as having steady, reliable cash flows that could be used to pay off debt may make sense.  By comparison, if you are talking with a strategic investor, the consistency of the cash flows may be less important than being able to show how your company will be able to grow quickly or reduce costs through synergies with their existing businesses.  In short, the better you can understand an investor or acquirers motivations, the better you can sell them on your company being a good investment.