Will Future Venture Funds Include a Dividend Component

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?