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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