Archive for January, 2007

structuring return

Fundamentally I’m interested in systems – clear rules make it easier for folks to know what they’ll get. I just can’t escape my engineer training. Right now how a company uses its earned value is something that gets negotiated in the boardroom – a place that employees almost never have representation, and a place where the balance of power (and so to some extent, the future goals of the company) gets negotiated during the investment phase. Investors demand board seats, or work to ensure significant stock ownership, to guarantee for themselves that management keeps investor return a high, or even the highest, priority. I don’t want to fight creators for ownership of their creation, but the alternative extreme to be wary of is that management takes investor money and then never makes good on it. No company agrees to liquidate by a certain date: managing a company is all about responding to opportunity. There are often “registration rights”, clauses whereby 2/3rds of the investors can vote to make the company register their shares – basically go through the process of going public – but that would be foolish if the company hasn’t been managed in a way to be a desirable IPO opportunity. I’d be interested if anyone knows of an instance where that has happened.

So I can protect myself by fighting for control (which I’m not really in a position to do), doing lots of due-diligence and trying to ensure that management and I have similar goals and that they have reasons (perhaps social relationship ones) to not just leave me hanging, or I can hope for the best and maybe sometimes get left hanging. I think that’s the worst case for an investment – one that doesn’t go anywhere and also doesn’t actually fold but lingers on for years at an uninterestingly cashflow positive level so I can’t actually write off the investment and be done with it. What I really want is to have a structure so that we all get paid the same way, and dividends seems like a way to do that.

When was the last time you bought a stock for its dividends? Perhaps I’m just not old enough yet, but as someone in my prime career years the concepts of stocks paying dividends just isn’t on my radar. In my experience so far as a private equity investor dividends are not spoken of. Oh sure, every investment agreement has some clause about the preferred stock dividend, they’ll often say something to the effect of “preferred stock is entitled to an x% dividend which gets paid ahead of any common stock, if the board of directors decides to declare a dividend. Those dividends may accumulate and if the company is sold they get paid out.” But the board would have to actually decide to declare a dividend.

Startups don’t declare dividends, and they might not be very receptive to my suggestion that they do. Somewhere along the line it seems to have become business cannon that dividends are bad because they’re “double taxed”. This refers to the fact that when you’re balancing the company’s books, you declare dividends out of the post-tax income – so the company has paid taxes on that income. Then that income gets paid to you, and then you pay taxes on it. If you are the sole business owner, a dividend distribution to yourself might feel taxed twice. However, this only applies to C-corps, which should be big enough companies that no one owner feels personal ownership of the corporate profits. S-corps, which is what a single small owner should have, are taxed differently.

Without dividends investors only benefit from raising the price of the stock. In the 1980s companies like Microsoft demonstrated that the interests of management, investors and even employees too could be aligned by giving everyone stock and options. Then we all benefit from increases in stock price. Companies piled onto that bandwagon. Unfortunately the stock price is at best a loose indicator of a company’s real value generation and we entered the area of stock price manipulation and the corporate crash.
“Well, there’s a saying in business, that profit is an opinion but cash is a fact. And by putting the focus on cash, stockholders will know this is real.” – “Senior Administration Official” 1/7/2003
The federal government responded to this by lowering the tax rate on dividends to encourage companies to use them more often as a tool to distribute income, though apparently that was done in a complicated way. I personally believe that paying taxes is part of being a good citizen, and I’ve persisted to believe that even during administrations I disapproved of. It’s unfortunate that there’s such resistance to dividends, because it makes sense to me that it is a more honest reflection of company performance than stock price, and therefore dividends could play the effective role of aligning the interests of shareholders, employees and management.

My inner-engineer points out that we’d need to change employee stock compensation from options to stock and management would have to figure out how that’s done. And to be technically correct investors still need to close the gap on management compensation to ensure that everyone’s incentive compensation comes via dividends. So using dividends still leaves a structure of the board being the place where investors negotiate with the friends of management (because how else do you get on a board?) over the application of company-created value and the rest of society just has to hope that they see themselves as stewards rather than win-lose competitors.

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I had a great conversation this week with someone who runs a community development venture capital fund. We got down to the core with each other of “what brings you to this table?” The table in this case is a fund designed to make money but balance that with growing jobs in the community. We ended up talking about how people get rewarded for hard work and how much luck is involved. I think interestingly we come to a similar place but from different directions: I get the sense he too often has been accused of merely being lucky and not working for what he has. I on the other hand feel I’ve witnessed many people take good fortune as a validation of superiority. The truth is that we’ve both worked hard, and we’ve both had some good opportunities.

The components of success: hard work, inspiration, opportunity. Looking at those as ingredients suggests that merely being exposed to opportunity is enough and that if one doesn’t take advantage of it then there’s either a lack of smarts or a lack of hard work. With that kind of framing it’s automatic to blame the non-achieving individual. But hard work isn’t an addable ingredient like that with a single opportunity. There needs to be infrastructure. When I look at how I’ve developed in my own life, and I reflect on sociology writings I’ve read about ambition and success, one opportunity is not enough. There needs to be a sequence of opportunities at the right time that create a reach opportunity with a reasonable chance of success to reward and thereby reinforce the hard work. That prepares the person to reach a little higher for the next opportunity. Multiple opportunities also give one a chance to recover from a setback. It’s pretty complicated to line up just the right set of learning so we can’t hand out opportunities like prizes on a game show: it needs to be raining opportunities of all kinds for people to get what they need to grow and become the best they can be.

I guess that’s what attracts me to this nexus of private equity and economic development. I want to help create a fertile environment where lots of people get to experiment and develop at lots of stages, not just the well-off, or the married to someone who can support me, or the young pup who reminds the well-off of their younger selves. We need fertile ground and lots of seeds if we want a vibrant economy.

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A quote I transcribed a couple years ago from a recorded speech that alas still sits on my desk.

“There are obvious and almost facile connections between the war in Vietnam and the struggle I and others have been waging in America. A few years ago there was a shining moment in that struggle. It seemed as if there was a real promise of hope for the poor, both black and white, through the poverty program. There were experiments, hopes, new beginnings. Then came the build-up in Vietnam and I watched this program broken and [?] as if it were some idle political plaything of a society gone mad on war. And I knew that America would never invest the necessary funds or energies in rehabilitation of its poor as long as adventures like Vietnam continue to draw men and skills and money, like some demonic destructive suction tube.”

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