This post is one of a series of Venture Capital Insights focussed on structuring seed-stage equity investments. Next up is to consider the investor’s attitude to yield, particularly why some venture stage investors build in a requirement for a dividend stream and why, paradoxically, they hope never to get any.
Background
Most scale-up businesses never generate any income for the investors. That’s usually not even the plan. It’s all about capital gain – usually through a medium-term trade sale or private equity transaction. The flow of cash tends to run the other way, as founders contribute sweat in excess of salaries, and backers contribute to follow-on rounds to fund continuing growth.
Consequently, many venture investors, and nearly all angels, don’t even think about dividends. Their investment documents are silent.
However, quite a few venture investors – and we are one – do specify a dividend policy. Given that our investment strategy is all about capital gain, why is that?
Example dividend policy
Here’s an example of a venture-stage dividend policy that founders might see in a termsheet:
The Company will adopt an ordinary dividend distribution policy for any financial periods ending after the third anniversary of completion, subject to adequate distributable reserves and VC approval, of not less than 30% of pre-tax operating profits. Such dividends will be paid pro rata to all shareholders. Our preferred strategy would be that any cash generated was in practice reinvested into the business provided that there were sufficient growth opportunities.
Let’s dissect that clause:
- Firstly, there’s no suggestion that dividends should be paid in the first few years. That’s just not going to be possible for a scale-up company. There’s no point even thinking about it.
- The venture investor isn’t getting a special deal. In the unlikely event that dividends were paid under this clause, it would be to all shareholders proportionately to their holdings. No-one is getting a preferred position.
- Most importantly, the obligation to pay a dividend can be, and almost certainly will be, waived by the venture investor. Their approach is set out in the last sentence – in a scale-up business, any surplus cash is usually best put to work back in the growing business.
So why does the venture investor even ask for a dividend policy?
Aim of the dividend policy
Like a lot of standard wording in venture documentation, the dividend policy clause reflects two factors:
- Generically, decades of experience across the venture capital industry of things going wrong, and finding ways of fixing them for the next investment;
- The relative vulnerability of the venture investor to the choices made by the founders.
That second point might seem odd to any founder who has ever been through an institutional venture round. Having signed up to pages of documents that give rights to the investor to attend boards and see accounts, and to be consulted on major decisions, the founders might feel that they are the ones who are vulnerable to the investor. There’s some truth in that view and a badly behaved investor can potentially be disastrous. From the investor’s point of view, though, there are massive risks running the other way. The biggest risk is the founder’s ability to execute on and refine the agreed strategy. Importantly, the venture investors do not have the power to change management. Neither can they stipulate a strategy (although they can try and advise). They also can’t sell the company from under the founders’ feet.
They’re really along for the ride – wherever you go, we go.
And sometimes, where the company goes is into an inverse-Goldilocks position. Not so bad that everyone calls it a day. Not so good that Big Tech makes an irresistible offer. Just right to throw off profits and cash and finally start paying some sensible salaries.
So where does that leave the venture investor?
Stuck!
They generally have a timeline to get an exit (maybe a 10-year life fund) but no ability to force one. Neither do they get any income out of their investment. Founders, on the other hand, may be in a very comfortable position – happily running their own business, being paid adequately, accumulating cash, with a fairly passive external investor who gives them little trouble, and a timeline that runs through to retirement years in the future.
In these circumstances, maybe the investor would be inclined to accept the founders’ slightly cheeky offer for their shares?
What the dividend policy achieves
The dividend policy doesn’t fix the problem entirely, but it does provide an equitable solution of sorts. If management want to run the business for cash, and not exit, it’s their choice but at least the investment starts to yield an income. That might make the venture investors’ position more tolerable, so that their Limited Partners are happy to consent to their holding the shares indefinitely.
Still, it’s not a great outcome.
What the policy really achieves in these (quite unusual) circumstances is to balance the negotiations about a buy-in of the investor’s shares by the founders. It gives the investor an option – to hold the shares for income – as opposed to sitting on a perpetually non-performing asset. And with options available, the two sides can have a genuinely sensible discussion about price.
Round-up
Venture Capital investors don’t invest for income. The dividend clause is there to make sure that founders and investors are aligned in their strategy from day-one: to achieve a capital gain.
Like most clauses in the investment documents, it’s almost certainly never going to see light of day again.
Partner, DSW Ventures