There’s been quite a few articles and blogosphere discussions over the past two years about the impending decline in the number of active venture capital funds (TechCrunch, WSJ, NY Times). Several trends cited for the decline of the size of the venture industry include:
- Negative returns for the venture industry over the past decade
- Asset allocation size readjustment due to overall asset value decrease (e.g. if a University endowment allocates 5% of assets to venture investing, and the value of the endowment drop 20%, which has happened to many schools, the original 5% allocated to venture is now significantly higher as a percentage of overall assets resulting in a need to reduce the amount put into venture on an absolute basis)
- Fewer liquidity events where a company is acquired or goes public (IPO)
- Lower cost to get a web company off the ground (but still expensive to scale)
- Longer time frame to exit a business of 7-10 years instead of the previous 3-5 years, requiring larger exits to get the same desired rate of return
- Lack of liquidity becomes significantly less desirable during times of market turbulence
A typical venture investment in a company is for preferred shares of stock, with protections for downside scenarios, as well a seat on the board of directors. Venture capitalists then make money for their limited partners when the company is acquired, the shares are purchased by another investor, or the company goes public. Generally, VCs will say they are shooting for an 8x-10x return on their investment (e.g. get eight times the money they put in).
In the public markets, a really simplistic way to think about the types of companies is to divide them into two camps: one type of company is focused on growth, doesn’t pay a dividend, reinvests profits, and is valued on its future potential whereas the other type of company pays a dividend, and is based on the value of future dividends. Usually technology companies are valued on future potential and companies that have a dividend, like banks, are valued on dividends (e.g. here’s a history of BB&T bank paying dividends).
Venture capitalists often invest in technology companies and the investment is based on the potential growth and eventual sale of the business. Therein lies the challenge: if fewer companies are exiting for nice returns, it doesn’t take as much money to build a technology company, and exits are taking twice as long, something has to change. Thinking about the two simplistic types of public companies outlined above, it makes sense for some future venture funds to take a hybrid approach where they have a dividend component on investments in order to provide smaller amounts of liquidity back to the limited partners earlier than normal, while still generating the majority of their returns from the sale of portfolio companies.
Let’s a take a look at an example:
- The VC invests $1,000,000 into a company for preferred shares representing 20% of equity and a 15% dividend starting after 12 months that can be converted to equity at investor’s discretion but is assumed to paid annually.
- If the company is growing fast, the dividend is converted to equity.
- If the company isn’t growing as fast as desired, a $150,000 per year dividend is paid. As an example, after five years, with no dividend in the first year, $600,000 would be paid, and 20% of equity still owned (assuming no new investors).
- If the company is sold for $20 million after the fifth year, the 20% is worth $4 million, plus the $600,000 dividend, results in a $4,600,000 aggregate return on the $1 million invested.
- The $600,000 dividend doesn’t move the needle for the total return but does provide liquidity and mitigates complete write-off potential for the investors.
My guess is that we’ll continue to see the trends that caused the decline in the size of the venture capital industry and by providing new approaches, like this one, investors will be more interested in participating.
What do you think? Will a hybrid venture capital approach that provides dividends make it more appealing for some investors?
5 thoughts on “Will Future Venture Funds Include a Dividend Component”
Seems that venture capital is growing and they don’t care about dividends as this doesn’t produce the return expected by investors. Plus, they already have guaranteed intetest rate on their investment. Seems that a dividend would not be attractive to the businesses as it kind of goes against the value proposition of venture capital. In my experience, high dividend investments are specific to cash rich businesses that don’t have the exit potential/ attractiveness, or have no plans to sell in the foreseeable future or higher then normal returns are expected in the early vs later years. Maybe I am off base here but my quick reaction to the concept.
Also, there is the concept in these deals of cumulative and non cumulative dividends. This is typically a point of negotiation as to weather the dividend is guaranteed or has to be declared annually based on business performance. Here is a great resource supporting that there has been an increase in deal flow recently quarter over quarter and over the prior period last year. The report was produced by PWC: http://www.nvca.org/index.php?option=com_docman&task=doc_download&gid=628
For VC to say they don’t care about dividends is merely sticking their fingers in their eas and saying “lalalalala”. VCs want a thriving tech IPO market and my daughter wants a pony. It just isn’t happening.
If VCs don’t pivot, they’re dead. Read Steve Blank’s latest
Maybe it won’t be as necessary for some business to even deal with VCs and losing equity. What about the guys from RevenueLoan (http://www.revenueloan.com/)? What do you think of their model?
I think other creative financing solutions like RevenueLoan make sense. I don’t think RL will ever be super popular but they can build a business. My gut says we’ll see more funds that limit their downside with more frequent cash dividends than historically as well as not as great upsides.