Is there a lesson in the news broken by Kara Swisher of AllThingsD that Airbnb founders have achieved (or plan to achieve) significant personal liquidity via a cash dividend? Should non-founder employees of hot startups exercise their stock options as they vest, to be eligible for early dividends, too?
Swisher's piece takes up the perennial question of whether it's fair for founders to cash out, not just in front of investors, but before employees.
But the Airbnb story also has a unique twist. While it's not unusual for startup founders to take money off the table in the course of a round of financing, it is unusual is for money to flow in the form of a dividend. Normally, early founder liquidity comes via a redemption or private resale of some of the founder's stock.
By distributing cash in the form of a dividend, the startup lets the founder eat her cake and keep it too. After the dividend, the founder not only has cash to save or spend, she keeps the same number of shares she had before the dividend. Put another way, the founder did not have to surrender, give up, abandon (i.e., sell) any shares in the company in order to get the extra payday.
Paying a cash dividend on common stock is not an easy thing to do. For starters, the company's charter will likely have to be amended to deal with prohibitions and preferred stock preferences. That means having the investors on board. There are also "unlawful distribution" statutes to consider. These are laws that prohibit distributions if the company is (or would be, after making the distribution) unable to pay debts in the ordinary course. For startups that are not cash flow positive, it can be hard to meet the requirements for a legal distribution, outside the context of a financing.
Does it matter whether the founders of your company get early liquidity via a dividend rather than by selling shares privately or on a secondary market?
Yes. When money is flushed from a startup in the form of a dividend, that means it has less working capital. Now, be ready for the creative financiers and lawyers who came up with this scheme to defend it. They will say that dividends to founders only happen with investor buy-in and careful planning to ensure money is raised, over and above the amount needed for working capital, to finance the dividend, too. But think about that argument for a minute. Investors aren't gifting the cash that will go out the door to pay the dividend; they are buying additional shares from the company, preferred shares most likely, in exchange for that cash.
In short, when you argue that a startup's working capital is adequate even after accounting for a founder dividend, you are admitting that more equity was sold than necessary, had the offering capped out when the company's working captial needs were met. The sale of excess equity means excessive dilution, at least in percentage terms, to outstanding employee options.
True, had the company redeemed shares instead of paying a dividend, there would be the same depletion of working captial, as well as similar dilution from new shares issued to fund the redemption. But when founder stock is redeemed, the retirement of those shares has a mitigating, anti-dilutive impact. Depending on the price differential (what the new investors pay for the shares sold to finance the redemption, over and above the price per share paid to the founder to repurchase her stock), a redemption could significantly increase what percentage of the company a given stock option represents.
If you exercise your vested options, then you own shares. When you own shares, any dividend paid on the common stock - even if targeted primarily for founders - will flow to you, too, pro rata, in proportion to the number of shares (not options, but shares!) you own. A good hedge on the potential for founder selfishness?
There are additional reasons to exercise options as they vest. I once sat on a board with a fellow who brought his checkbook to every meeting and exercised the new portion of his option that had vested since the last meeting. He was thinking in terms of maximizing long term captial gains treatment for his equity on exit.
He also believed in the startup and wasn't worried about losing his investment. That's the risky bit. If you exercise your stock options as they vest, the exercise price you pay is an investment that could be lost. You aren't hedging against failure like those who sit on their options until the company is sold.
What's more, your investment risk is greater than that of a preferred stock investor, who will have the benefit of a liquidation preference. Liquidation preferences can be worth a multiple of the amounts originally invested. It's essential to know them and to understand them in order to assess how the common stock will fare in the distribution of proceeds from a sale of the company. These days, it is all too common for exits to be carefully managed to clear liquidation preferences, leaving common stock worthless. As for C-level execs whose options are underwater, they can be "incentivized" through a "sale participation plan" set up exclusively for management. You may think execs with stock options have the same incentive as you do to deliver upside to common shareholders, but that may not be true.
In a way, that brings us full circle. There probably is no sure fire way to hedge against founder willingness to break ranks with employees. If founders are willing to cooperate with investors on early dividend schemes, they may also be more willing to "manage" the company to an exit that treats the common stock - not their common stock, but yours - as an afterthought.
Photo, "Lunchtime at a startup, 6:30 pm at @airbnb with co-founders @jgebbia @bchesky," by Robert Scoble.