Paying dividends is just one way of returning investors’ money. Should your startup pay dividends? Read more to find out.
Dividends are a company’s profits that are distributed among its shareholders as a return on their investment. The payout can come in the form of cash, shares of stock, or other assets, and can be meted out at different timeframes and rates.
When you invest in a mature company, you usually receive dividends quarterly or yearly. Over 80% of S&P 500 companies pay dividends, and this is taken as a given for public companies. However, it is surprising when a private company like a startup pays dividends.
For one, dividends are usually paid by stable, mature companies that are self sustaining and do not need to invest all of their earnings back into the business. Investors, of course, find this attractive. Dividends represent a stable income and a company that is confident about its prospects. This in turn can prompt more people to invest in the company’s stock, boosting its price and thus increasing the value of investors’ holdings.
So, startups paying dividends is almost never heard of because they usually choose to reinvest their earnings into the business. When startups are growing rapidly, they require funds, and it is more prudent to hold on to the earnings and reinvest them. After all, that’s why startups raise funding rounds in quick succession – to support their development, growth, and expansion strategies and someday, make their investors a lot of money.
That said, even some bigger companies choose not to pay dividends in preference of funding new projects or paying off debt. And this reinvesting, too, can lead to a hike in share prices and result in capital gains for investors.
One venture capital-backed startup that did pay dividends was Kickstarter. So, while startups paying dividends are rare phenomena, they do happen. It depends on the startup, its founder, and its growth strategy, among other factors. But more often than not, startups won’t pay dividends and founders will generally avoid discussing or agreeing to terms involving dividend payouts.
How do investors earn if startups don’t pay dividends?
When investors put money in a startup, they usually only cash out when the startup attains an ‘exit’ for them. Typically, investors exit either when the company is acquired, or when the startup goes public through an initial public offering (IPO) or a reverse-merger with a listed company.
When the startup lists on a stock exchange, it raises a huge amount of money by selling its shares to the public. From this fundraise, institutional investors take their return on investment (ROI) and sell their shares in the startup.
Similarly, when a startup is acquired by another company, the amount received from the sale is divided among the founders and the investors according to their ownership share.
But when startups like Kickstarter shun the traditional exit routes, they have to ensure that their investors get returns sooner or later. Paying dividends is the best way to do that. However, since VCs in general operate with a 10 year window to get returns, the dividends need to be meted out within that timeframe, and need to offer a satisfactory rate of return.
Venture capitalists basically look for fund-returning payouts, which is generally only possible when a company goes public or gets acquired. Agreeing to pay dividends signals to investors that the startup is looking to become a positive cash-flow business that can pay dividends instead of a venture-scale business that can return the full investment with an attractive ROI.
What’s in it for investors if startups pay dividends?
According to entrepreneur and author Bobby Martin, best known for his book, The Hockey Stick Principles: The Four Key Stages to Entrepreneurial Success, there are several reasons why investors could ask for dividends.
Firstly, selling a company is not easy, what with the endless number of tech startups floating in the market. And finding a buyer can be more difficult if the startup operates in a niche market. Since they operate in a small market with small prospective profit, they are not always the best find for strategic buyers.
Martin claims that dividends have a good ROI, but it is important to note that Martin is an angel investor. Compared to VCs, angels invest relatively low amounts of money that can be recovered through dividends more easily than VC investments of millions of dollars.
Most importantly, Martin claims that a smart business model can pull off growth and pay dividends as well. If a startup has a steady growth rate and a good profit margin, paying dividends is possible without compromising on growth, he says.
However, it is important to remember that most startups remain unprofitable for a long time. So, paying dividends, consequently, may not even be possible for some.
Ultimately, what is important is not the way startups offer their investors ROI – listing, sale, or dividends – but that they offer a clear roadmap for investors to get their money back and more. Without offering a clear path to a profitable return on investment, a startup will fail to secure funding, and from there, survival becomes more and more of a challenge.
Header image by Zachary Kadolph on Unsplash
