Let’s delve into the realm of fantasy for a moment. A realm where VCs and their limited partners are not simply guided by home-run returns, but by the possibility of ongoing dividends as well. Where the art of creating sustainable private companies, and the benefits of actually keeping those companies private for the long term, represents a viable income option for venture capital firms and their limited partners.
Though it may seem like fantasy – or folly – this concept has worked many times before: Bechtel, Cargill, SAS. Huge examples of well-run private companies that have reached the scale of some of the largest publicly traded companies, yet with far fewer headaches to deal with. Could we as venture capitalists offer our entrepreneurs the same opportunity? Could we even convince our limited partners that, in certain circumstances, such a strategy of keeping startups on the path of staying private might make sense, offering limited partners steady dividends on retained earnings at a time when other investment alternatives still seem largely uncertain? I believe so.
Lesser of Two Evils?
Break down this argument into its logical parts and the concept of keeping venture-backed companies private may not seem that far-fetched. Certainly the alternative has not proven that attractive. Consider the following: Thomson Financial (publisher of VCJ) reports that bankers expect a record number of U.S.-based publicly traded companies to actually leave the public markets this year. They want to get out from under the burdens of complying with all of the rules and regulations (namely Sarbanes-Oxley), not to mention the costs, which now go hand in hand with trying to succeed on the New York Stock Exchange or Nasdaq. Fifty-three public companies took themselves private just three years ago, and 86 more did the same last year. The number of firms exiting, rather than entering, the public markets could exceed 100 this year.
There are a variety of factors that have caused such a dramatic shift in the desire for companies to stay public or to go public in the first place. First, small and mid-cap companies are, unfortunately, under the same requirements of their larger-cap brethren when it comes to complying with the high costs of the Sarbanes-Oxley corporate governance legislation, as well as other new SEC rules and stock exchange listing requirements. One recent report estimates that this compliance has resulted in a doubling of budgetary outlays to an average of $2.3 million per company per year, specifically for those companies with market valuations under $900 million.
The burden falls hardest on companies with revenue between $100 million to $250 million-several million dollars spent on compliance costs represents a huge chunk of valuable capital spent on non-revenue producing necessities. And the outlook only gets more expensive. As new regulations are phased in, companies will be required to document their internal control procedures for everything that ends up in their financial statements. For a company like Niku, where I am a board member, this new reality literally takes precious capital out of their pockets, capital that could have been used to enhance shareholder value or expand the business model into new markets and new revenue streams.
Further factors discouraging private companies from becoming public also involve the changing face of Wall Street itself. Even after a nice comeback in market valuations, small and mid-sized firms included in the Russell 2000 small-cap stock index still trade at just 2.16 times their book value. This compares with large cap stocks within the Dow Jones Industrial Average, which trade at 3.44 times their book value. Until 1998, these two groups roughly traded on par with each other.
Now, with the discrepancy in valuation having grown so wide, there exists further evidence that the smaller growth companies in our portfolios, the same ones that we had hoped to take public sooner rather than later, simply don’t have a lot to look forward to. In fact, unless the companies have the size and scope – and hype – of a Google, there are better than even odds that they won’t be valued nearly as richly as their large-cap brethren.
Several factors are working against small-cap and mid-cap companies. There has been a fundamental shift in Wall Street analyst coverage. Also, only companies with valuations north of $500 million have enough liquidity to satisfy the bulk trading volume requirements of hedge funds, mutual funds and institutional investors that now occupy a predominant share of market activity. Small and mid-cap companies are thus caught in a squeeze, as they can neither afford to remain public, nor can they count on any kind of rising tide of investor enthusiasm to support their shares if they choose to do so regardless.
What all of this adds up to is a public markets environment increasingly unfriendly to venture-backed companies seeking the exchanges as their best exit strategy. Though VCs and their limited partners understandably want the liquidation opportunities the public markets afford, if they go that route they might be selling portfolio companies into a market framework destined to inhibit the future growth of what we’ve already tried to build: robust young companies
The Dividend Approach
Now let’s consider the obvious (and perhaps not so obvious) benefits of remaining private. First, to be a public company in today’s markets is to essentially be the equivalent of a reality TV show, opening the Kimono on the inner workings of the company, including its financials. Private companies, however, retain the advantage of stealth. That allows them to manage their firms and their finances below the radar of much outside scrutiny.
Not only does this help private companies make decisions for the long term without being questioned by analysts holding them to quarterly earnings numbers, they can essentially show as little or as much of themselves as they want. That’s a huge and often overlooked benefit when pitching to potential customers. If a public company, such as Niku, is competing for a deal against a well-funded private company, basically all of Niku’s financial information has already been laid out on the table, including available cash, debt obligations and stock price. Its private company competitor, however, can point to recent financings and customer references and suddenly the outlook for future company viability looks far rosier for the private company than for the public one.
So what’s the answer for VCs who are itching for exit strategies, who need to produce returns for their limiteds? One option – aside from the obvious liquidation opportunity of an M&A transaction – is for a private company to dividend back a pro-rata portion of retained earnings. Clearly, this decision depends on the net present value of all future dividends over a certain number of years vs. the short term opportunities of trying to get all of my investment out in one clip and then some. It also depends on my desire as a VC, and the desire of my limiteds, to either hold onto distributed shares for the long term should we take a company public, or sell out on an IPO.
Put another way, if we opt for a retained earnings approach and keep the company private, are we essentially trusting company management to “manage” our capital as well or better than we could if we had all that money coming to us in our pockets? Or if we hold onto public stock for the long term, can management guide the company through challenging public market waters, such that our shares would appreciate further?
The real answers lie somewhere in the middle. Should VCs give up taking companies public? Of course not. But the decision-making continuum between whether to sell a company at an earlier stage in its valuation or take it public at a later stage in its expansion is clearly growing longer. In short, if we want to sell companies, it may pay to sell them earlier, say only up to valuations of $200 million or less, and take them public later, say at roughly $500 million or more. This allows venture-backed companies to bake longer in the private markets without the Wall Street scrutiny, regulatory burdens or other potential competitive advantages facing small-cap stocks.
A retained earnings alternative may exist if (a) M&A opportunities are absent or offers are far too low for the potential value of the company, (b) the public markets become even more selective, demanding that pre-IPO companies have the potential for billion dollar market valuations or more to get noticed and appreciated; and (c) limited partners agree – a big if, admittedly – that retained earnings dividends of, say, 9% sound fairly appealing given all other exit opportunities, and the opportunity costs of shifting that invested capital elsewhere seem too high.
Put another way, every dollar I would get out of a company as a dividend would have to be worth more to me than leaving that dollar in the company for the foreseeable future.
“I don’t think many VCs or their limited partners would go for it, so this seems mostly like an intellectual exercise,” says one VC, whose firm invests on behalf of one of the world’s largest private companies. Yet, he does admit that for strategic reasons, and because the firm is satisfied with current dividend returns, two companies in his portfolio remain private and will likely stay that way, yielding dividends between 9% and 10 percent. “The problem is that even at a 9% dividend, it’s very hard for a VC to get all of its capital out. For us, as a large company, it’s fine, but for more traditional VCs it’s an issue. And that issue is, Is CalPERS as a limited satisfied with that 9% return?’ The argument can be made that for them, and in this overall market, 9% is good enough.”
Weighing all other alternatives, sometimes a 9% dividend on a few select portfolio companies seems good enough indeed.
Ravi Chiruvolu, a general partner of Charter Venture Capital, is a regular technology columnist for VCJ. Send him feedback or ideas to email@example.com. Chiruvolu specializes in enterprise software, software infrastructure, e-business and wireless. He sits on the boards of Ellie Mae, ManageStar, Niku (NASDAQ: NIKU), Quantum3D, Talaris, Verano and Winery Exchange.