Why dividend cash-outs are evil

By Felix Salmon
October 2, 2011
leaked to Kara Swisher.

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Investor Chamath Palihapitiya wrote a strongly-worded letter to Airbnb CEO Brian Chesky yesterday, which promptly got leaked to Kara Swisher.

Palihapitiya was given the opportunity to invest in Airbnb’s latest round, but declined, partly because of the way it’s structured. Airbnb’s executives are taking $31 million in cash as part of the deal, and Palihapitiya was actually OK with that. But his problem was that $22.5 million of that is coming in the form of a dividend — which makes it look pretty evil, in an early-stage company where many employees only have options.

“If you want liquidity, that’s fine, but you should make it available to everyone,” wrote Palihapitiya, adding that “dividends are an approach used by cash rich operations to distribute excess earnings”.

In case Palihapitiya’s point isn’t clear, let me explain with a much simpler company, with just two founders and one new shareholder.

Adam and Bill set up a company — let’s call it Bubbl. The way the structure is set up, Adam has 1 million shares in Bubbl, while Bill has 1 million options to buy Bubbl stock at $1 per share. Bubbl is successful enough that potential investors start circling, and eventually a deal is done whereby Charles will pay $1 million to buy 200,000 shares at $5 per share.

Historically, such a deal would be pretty simple. Bubbl issues 200,000 new shares, which are sold to Charles for $5 each. And so after the investment, Adam still has his 1 million shares, Bill has his 1 million options, and Bubbl has $1 million of cash in the bank. Working on the assumption that at some point Bill will exercise all of his options, Adam’s stake in the company has gone down from 50% to 45.45%, since the total number of fully-diluted shares outstanding has risen from 2 million to 2.2 million.

Adam’s now worth $5 million on paper: he owns 1 million shares which are worth $5 apiece. And he owns 45% of a company with $1 million in the bank, so in a sense he has $450,000 in cash. But he can’t spend that cash — it belongs to Bubbl, not to Adam. The problem is, Adam wants to buy a nice house. And Bill, too, likes the idea of making some fast cash. So instead of doing this kind of old-fashioned deal, Adam and Bill decide that they’re going to do a cash-out deal instead.

Charles still buys 200,000 shares at $5 each, but Bubbl doesn’t issue any new shares this time. Instead, Adam simply sells Charles 100,000 of his 1 million shares. And Bill exercises 100,000 of his 1 million options, buying 100,000 shares at $1 each and immediately selling them to Charles for $5 each.

At the end of all this, there are still only 2 million fully-diluted shares outstanding. Adam owns 900,000 of them, which gives him the same 45% stake. But he also has $500,000 in cash. Bill has 900,000 options, and $400,000 in cash. And Bubbl has $100,000 in cash, which it got paid by Bill when Bill exercised his options.

Now, let’s take our first step into the world of evil, and suppose that Adam doesn’t feel any particular need to look out for Bill’s interests. Bill isn’t a shareholder yet: he just has options. So instead of letting Bill exercise some of his options, Adam decides to sell the full stake to Charles himself. His shareholding drops to 800,000 shares, he gets $1 million from Charles, and he ends up with a 40% fully-diluted stake in the company, compared to the 50% stake that Bill will have when he exercises his options.

Adam’s choices here are pretty clear. He can make sure that Charles’s $1 million stays in the company, take no cash for himself, and end up with a 45.45% stake. He can put just $100,000 of Charles’s money in the company, take $500,000 of it for himself, and still end up with a very similar 45% stake. Or, he can take all of Charles’s $1 million in cash for himself, and end up with just 40% of Bubbl.

Or, Adam could get really evil. This time, Bubbl issues 200,000 shares to Charles in return for $1.2 million. Bubbl then has $1.2 million in the bank, and distributes all of that money to its shareholders, as a dividend. Now remember that Bill only has options: he doesn’t have any shares. The only shareholders, right now, are Adam, with 1 million, and Charles, with 200,000. So Adam gets $1 million of the dividend, while Charles gets $200,000 of his own money back.

The net result for Charles is the same: he’s spent $1 million in total, and received 200,000 shares. But Adam is sitting pretty: he has 45.45% of the company, plus $1 million in cash.

This is a much better option, for Adam, than the other three: he manages to maximize his fully-diluted shareholding in the company, and get $1 million in cash. Adam has cashed out, here, but has also kept all of his shares: a classic case of having his cake and eating it. And Bill, of course, gets nothing: no cash, and no cash in Bubbl’s bank account, either. In fact, he’s been diluted. If Adam just sold some of his shares to Charles, then Bill would retain his 50% stake in the company after he exercised his options. But this way, Bill gets diluted down to a 45.45% stake.

Essentially, Adam is taking money from Charles, and he’s taking equity from Bill. At least Charles is getting something in return: Bill isn’t.

Which explains what Palihapitiya was thinking when he wrote this:

I would implore you to not take the easy way out. Treat your employees the same as you’d treat yourself. Do things that you will be proud of and can defend to anyone including your Board, employees, prospective hires etc. In such a competitive hiring market, you are competing with not just your obvious competitors, but also any successful tech company who is also looking for great talent. A principle that treats your employees as well as you’d treat yourself is a huge strategy for differentiation, retention and long term happiness of the exact types of people you will need to be successful. In contrast, if you are viewed as self-dealing and shady, it will only hurt your long term prospects.

It was only two months ago that Chesky was forced to grovel to the public, admitting that he had “really screwed things up” when a woman’s apartment was ransacked by Airbnb guests. He’d learned, he said, that “you should always uphold your values and trust your instincts”. One’s forced to wonder, given the structure of this latest round, just how long that lesson lasted.

Update: Palihapitiya has now written a follow-up letter to Kara Swisher, “prepared in discussion with Chesky and Airbnb’s board”, in which he says that he will participate in the round after all, in return for promises from Chesky to allow employees to cash out in future. In contrast to the original letter, it’s full of jargon (“strategic intent to balance employee and founder liquidity which will align long term interests”) and seems to represent the triumph of greed over principle.


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Felix – please email me privately – i would like to invest in Bubbl – price is no object.

Posted by KidDynamite | Report as abusive

Would this not be covered by anti-dilution provisions in the option? Obviously it would vary from agreement to agreement, but it seems like the option-holder should be contractually protected from this.

Posted by bobman5352 | Report as abusive

Great post, Felix. Question about the terminology in your example: are the options you’re talking about here actually warrants since (it seems) when they’re exercised, the company is issuing new shares that dilute existing shareholders?

Posted by shubik | Report as abusive

You have to wonder whether he has forgotten the lesson, or whether he learned the lesson, but has a problem with the “values” he needs to uphold.

Posted by Kayza | Report as abusive

Great post. Talk about burning bridges.

Posted by SocialDenise | Report as abusive

I believe the email said $21m in cash, not $31m.

Posted by finsrud | Report as abusive

Enjoyed reading your post,Felix. It helped understand the issue at hand. Thanks

Posted by FinLeanrer | Report as abusive

” (he) says that he will participate in the round after all, in return for promises from Chesky to allow employees to cash out in future”. This is another way of saying “the check is in the mail”.

Palihapitiya has sold out.

Using dividends to reward execs? Unless the execs put up cash for some of their shares, how would that be done? Don’t they mostly have options? This sounds like a way to reward early investors, like maybe a way for them to pay for this new stage investment without putting up any cash.

This isn’t the kind of innovation that is needed in the finance industry.

Posted by KenG_CA | Report as abusive

nice post

Posted by Talmide | Report as abusive

I may be mistaken but, isn’t what Felix outlined more or less precisely what oracle does for it’s execs on what seems like a daily basis, except replace Bill with Oracle’s shareholders.

Posted by sunnohh | Report as abusive

Felix, pardon my naivety but in the last “really evil” example you mention that “Adam is sitting pretty: he has 45.45% of the company, plus $1 million in cash.” This means Adam did dilute his stake from 50% to 45.45%, right? So it is not that he isn’t giving up any stake.. he is giving up around 5%, and snatches 5% from Bill so that Charles gets 10%, and Bill doesn’t get anything for that 5% that was taken from him.

Am I making sense here? or did I misunderstand something?

Posted by abhim12 | Report as abusive

“He can put just $100,000 of Charles’s money in the company, take $500,000 of it for himself, and still end up with a very similar 45% stake” — can someone explain this transaction? I understand re-investing all the money, or keeping all the money.

Posted by mmulvi | Report as abusive

Felix, control is worth something. Read Marty Whitman. Every investor has to think in terms of the rights that he possesses with the securities he holds, and the rights that others have over the same group of assets.

That’s why structurally weak securities frequently have covenants for protection, particularly in private markets, and junk-rated securities.

I’m not sure I would call this “evil.” Unless there is some implicit fraud where the legal terms were hidden from or misrepresented to one of the parties, that securities have different rights, powers, and prices is normal.

Outside passive minority shareholders always have a weak position versus insiders with control advantages and greater knowledge, which is why intelligent outside passive minority shareholders look for management teams that will treat them well.

You are your own best first line of defense. Buyer beware.

Posted by DavidMerkel | Report as abusive

I simply don’t think I can agree. Options give you one set of benefits and liabilities. Ownership gives you another. Those who hold the stock–not the options–are the owners of the corporation. The corporation exists to make money for the owners.

It may be that option-holders will feel hard done by, especially if they are still waiting to be able to exercise. But employees can feel equally hard done by when owners choose to declare a dividend rather than give pay raises. You can call any dividend whatsoever “evil” by going down this path.

In this modern age of ours, we seem to have almost forgotton what stock is: it is ownership. Nothing much is going to make sense if we don’t keep that in the front of our minds.

Posted by ckbryant | Report as abusive

The content of Palihapitiya’s e-mail is right on target. I would hope that other investors agree, as it would be a shame for this practice to become common.

A big part of the problem is that…well, it was an e-mail. Not really an appropriate topic for e-mail.

More at: http://bit.ly/oBp3nR

Posted by YourOwnGC | Report as abusive

ckbryant, when you join a start-up, there is an unwritten agreement that you make sacrifices (e.g., work extra hours) and in exchange, you get to participate when the value of the company increases. This agreement is broken when special deals that benefit only investors are made. If the company is not profitable, then cash shouldn’t be distributed. If the cash is not needed, then the shareholders (and options-compensated employees) shouldn’t have their shares diluted by unnecessary funding, especially when that funding is only used to pay off earlier investors. Those investors should have to wait, just like the employees who are investing their time.

the dividend is not evil, but the limited distribution is unethical.

Posted by KenG_CA | Report as abusive


I don’t want to say that this isn’t sharp practice, and I don’t want to say that the employees of Airbnb don’t have a legitimate gripe here. But the word Felix used, many times, to describe this deal was “evil.” I think we’re both in agreement that this is not appropriate. So let’s start by setting that aside.

The second point I would make is that the employees still do get to participate in the increased value of the company. Their options are worth less than they would like, but they are still worth something. I would want to know to what extent the employees are vested in their options before saying much more about this–if they simply haven’t bothered to exercise yet, there is much less to get angry about than if they have been unable to do so.

For my part, I’m simply not a big fan of options, and I wasn’t even when I was working in the startup world, largely because my interest in “unwritten agreements” in business is too small to be seen by the naked eye. I regret that anyone working for Airbnb got screwed, but I imagine that most of them are smart enough to understand that they’re working for a pretty shady outfit by now, however many New Age platitudes their executives utter. I hope they’ll be more careful with their trust and with reading the fine print in future…

…but of course, if an epidemic of caution and fine-print-reading breaks out anytime soon, there goes the whole Airbnb business model!

Posted by ckbryant | Report as abusive

ckbryant, why is the word “evil” not appropriate?

Treating somebody unfairly, just because they can’t stop you from doing so, is very simply evil. It might not be quite as horrible as murdering children, but there is much evil that falls short of that.

Perhaps the nation could use a little less “Wall Street ethics” and a little more traditional ethics?

Posted by TFF | Report as abusive

Felix, nice article. This kind of behavior is becoming more and more common in Silicon Valley deals. I wrote up my own experience with an acquisition where there were some questionable aspects to the deal. http://www.mischievous.org/2011/10/quest ions-of-fairness-in-silic.html

Posted by jculverhouse | Report as abusive