Pre-IPO Dividends

By August 25, 2021Other

Some companies pay dividends to shareholders shortly before going public. This particular behavior raises an important question. Considering IPOs are traditionally seen as a way to raise capital, why would a company expend capital shortly beforehand? Despite the conceptual questions these payments raise, from a research standpoint, these payments are made by enough companies to be economically significant. 1 The fact that these payments are so prevalent and significant should cause other pre-IPO companies to consider whether these strategies and payments are a relevant consideration in their situation. This article will focus on situations in which companies that are preparing for an IPO would choose to offer dividends. Some of these principles apply to private companies generally, but these situations are not the focus of this article.

Companies might choose to pay pre-IPO dividends for several reasons. These reasons include the nature of the industry, the opportunity for investors in the company to achieve greater liquidity from the IPO, and the opportunity to optimize the valuation of a firm’s cash. Some of these explanations line up well with the reasons that a company may choose to offer a dividend after going public, especially in the case of companies that are already regularly paying dividends. This is because deciding if and when to offer a regular dividend is influenced by similar factors whether a company is public or not. More information about these factors can be found in our article about post-IPO payout initiations. However, the one-time pre-IPO dividend payments are often explained by factors that are unique compared to the initiation of a regular, recurring dividend payment.

Companies that offer pre-IPO dividends fall into two main categories. The first category includes companies that regularly pay dividends before their IPO. The second category includes companies that pay a one-time, special dividend relatively close to the time of their IPO.

Regular Pre-IPO Dividend Paying Companies

There are a variety of factors that normally lead a company to initiate dividends before going public. These factors include industry dynamics and regulations and the stage of a company’s development. In the right circumstances, these factors require or incentivize a company to pay a dividend to its private shareholders.

Industry Dynamics

Many companies pay pre-IPO dividends due to either industry regulations or industry norms. In many cases, the law requires firms that fall under certain legal classifications to pay a certain percentage of their profit in dividends. In other cases, most firms in the industry simply choose to pay dividends because this is seen as the norm. This is often the case with companies that operate in industries that have relatively slow growth but high cash flow. Companies that pay dividends because of industry dynamics often pay a regular dividend before and after the IPO.

For example, some types of companies, such as real estate investment trusts (REITs), face legal requirements to pay a dividend. The law specifically requires REITs to pay 90% of their taxable income to shareholders in order to maintain their legal status as a REIT. This regulation applies whether the company is private or public. Similar to REITs, master limited partnerships (MLPs) generally pay dividends before and after their IPO. However, unlike REITs, MLPs are not required to pay dividends by law. Rather, these organizations have partnership agreements that often include distribution requirements for the income of the company. Thus, these organizations often self-impose dividend-paying policies.

MLP Dividends Example: Cone Midstream Partners LP

Our partnership agreement requires that we distribute all of our available cash quarterly. This requirement forms the basis of our cash distribution policy and reflects a basic judgment that our unitholders will be better served by distributing our available cash rather than retaining it because, among other reasons, we believe we will generally finance any expansion capital expenditures from external financing sources. Under our current cash distribution policy, we intend to make a minimum quarterly distribution to the holders of our common units and subordinated units of $0.2125 per unit, or $0.85 per unit on an annualized basis, to the extent we have sufficient available cash after the establishment of cash reserves and the payment of costs and expenses, including the payment of expenses to our general partner. However, other than the requirement in our partnership agreement to distribute all of our available cash each quarter, we have no legal obligation to make quarterly cash distributions in this or any other amount, and the board of directors of our general partner has considerable discretion to determine the amount of our available cash each quarter. In addition, the board of directors of our general partner may change our cash distribution policy at any time, subject to the requirement in our partnership agreement to distribute all of our available cash quarterly[…]2

A firm may also have dividend obligations to private shareholders. For example, if a firm has backing from a venture capital (VC) or a private equity (PE) group, then there is also a possibility that the equity agreements with these groups require dividends. Many VC Term Sheets involve a dividend agreement. Most of these dividends are paid out only when the company goes through a liquidity event and are often paid in shares of common stock rather than cash. However, there is a chance that cash dividends will be required of a company depending on the exact terms of their agreement. For more information on these types of agreements, see our article about term sheets. There is also the possibility that other equity incentive plans exist with the private shareholders. The example below is taken directly from the S-1 statement of Casa Systems, Inc. As is the case with the example below, often these pre-IPO dividend agreements end when the company goes public.

Shareholders’ Equity Incentive Plans Example: Casa Systems, Inc.

Dividend Policy

Prior to our initial public offering, we declared special dividends in November 2017, May 2017, December 2016, June 2016 and November 2014. The November 2014 special dividend totaled $27.6 million in cash payments to our stockholders. In connection with the November 2014 special dividend, our board of directors also approved cash payments totaling $2.4 million to be made to holders of our stock options and stock appreciation rights as equitable adjustments to the holders of such instruments in accordance with the provisions of our equity incentive plans. The June 2016 special dividend totaled $43.1 million in cash payments to our stockholders. In connection with the June 2016 special dividend, our board of directors also approved cash payments totaling $6.9 million to be made to holders of our stock options, stock appreciation rights and restricted stock units as equitable adjustments to the holders of such instruments in accordance with the provisions of our equity incentive plans. The December 2016 special dividend totaled $171.4 million in cash payments to our stockholders. In connection with the December 2016 special dividend, our board of directors also approved cash payments totaling $28.6 million to be made to holders of our stock options, stock appreciation rights and restricted stock units as equitable adjustments to the holders of such instruments in accordance with the provisions of our equity incentive plans. The May 2017 special dividend totaled $87.1 million in cash payments to our stockholders. In connection with the May 2017 special dividend, our board of directors also approved cash payments totaling $12.9 million to be made to holders of our stock options, stock appreciation rights and restricted stock units as equitable adjustments to the holders of such instruments in accordance with the provisions of our equity incentive plans. The November 2017 special dividend totaled $43.0 million in cash payments to our stockholders. In connection with the November 2017 special dividend, our board of directors also approved cash payments totaling $7.0 million to be made to holders of our stock options, stock appreciation rights and restricted stock units as equitable adjustments to the holders of such instruments in accordance with the provisions of our equity incentive plans.

Although we declared and paid the special dividends described above, we do not anticipate declaring cash dividends in the foreseeable future. Any future determination to declare dividends will be made at the discretion of our board of directors and will depend on a number of factors, including future earnings, capital requirements, financial conditions, future prospects, contractual restrictions and covenants and other factors that our board of directors may deem relevant. Our credit facility contains covenants that limit our ability to pay dividends on our capital stock. 3

Company Lifecycle Stage

The data clearly show that most companies pay dividends when they reach a certain stage of maturity. This is often referred to as the life cycle theory of dividends. As a company ages, its growth often slows, and the company’s priorities shift from growth to profits. By generating a profit, companies can continue to provide value to shareholders, which often takes the form of a dividend payment in these later stages of maturity. If a company reaches this stage of maturity before going public, then it may have already started paying a regular dividend to its private owners. Thus, when the company goes public, it is likely to continue paying dividends like it has in the past. The fact that the company has been paying dividends, and that it plans to continue doing so, is communicated to IPO investors in the company’s registration statements.

One-Time Pre-IPO Dividend Paying Companies

Some companies that have not paid dividends, and that do not plan to pay dividends after the IPO, still pay a large, one-time dividend shortly before going public. In some cases, these payments are so large that they nearly match the capital expected to be raised in their IPO. One of the most famous examples of this is Burger King’s IPO in May 2006. In its amended S-1 registration document, Burger King related the following information about a one-time pre-IPO dividend payment:

On February 21, 2006, we paid an aggregate cash dividend of $367 million to holders of record of our common stock on February 9, 2006. At the same time, we paid the compensatory make-whole payment of $33 million to holders of our options and restricted stock unit awards, primarily members of senior management. 4

Surprisingly, the amount paid in dividends before the IPO was very similar to the estimated proceeds that were disclosed earlier in the registration process:

We will receive net proceeds from this offering of approximately $374 million assuming an initial public offering price of $16.00 per share, the midpoint of the range set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses. 5

This large, one-time dividend payment may seem counterintuitive. However, Burger King is not the only company that has engaged in this type of behavior. Many companies have made and continue to make similar dividend payments. The reasons why companies make these payments vary, but two of the most common explanations are dividend recapitalization and valuation concerns.

Dividend Recapitalization

One potential motive for companies to offer large dividends immediately prior to their IPO is to provide a guaranteed return for company insiders or other private shareholders. In other words, paying a pre-IPO dividend could be seen as an exit opportunity for investors in the private company. Many companies finance a large, one-time dividend payment with debt. This action is referred to as dividend recapitalization. This is a common strategy because it can offer a guaranteed return to early investors before the equity is exposed to the volatility of the public market. However, companies need to be able to handle the increased leverage. Otherwise, the increase in debt can contribute to eventual bankruptcy.

One reason many companies choose to engage in dividend recapitalization immediately prior to their IPO is to avoid sending a negative signal during the IPO process. During an IPO and afterwards, companies can sell new or existing shares. New shares are referred to as primary shares, and the existing shares belonging to the private investors are referred to as secondary shares. The capital raised from the sale of primary shares belongs to the company going public. In contrast to primary shares, the funds from the sale of secondary shares go to the current equity-owning shareholder instead of to the company. Secondary shares are an exit opportunity for equity holders. When private shareholders offer a large portion of their shares around the time of the IPO, they send a negative signal to the market. Investors interpret the sale of shares from private shareholders as a signal that something is wrong with the company or with its future prospects. This assumption can cause the stock price to fall, lowering the valuation of the company and making subsequent equity offerings more difficult. Thus, existing equity holders may want to find a way to exit their investment without decreasing the company’s valuation once the company goes public.

In order to deal with the problem of offering secondary shares, many companies have used dividend recapitalization by making large, pre-IPO dividend payments. This is done by the company paying a cash dividend and then offering more primary shares in order to finance the IPO dividend payment. In this way, pre-IPO shareholders can capture more value, or have a way to capture some of the value of the IPO, without needing to send a negative signal to the market.

Companies are required to give investors information about their history of paying dividends when they register to go public. Thus, if a firm decides to use dividend recapitalization in the period leading up to the IPO, they are required to relate this information to investors. The example below is taken directly from the Form S-1 registration statement of the company GoodRx when it filed for its September 2020 IPO.

Pre-IPO Dividend Recapitalization Example: GoodRx Inc.

In May 2018, we paid a special dividend to our stockholders in an aggregate amount of $154.4 million, and paid accrued dividends to the holders of our convertible preferred stock of $18.6 million. The dividends were financed with net proceeds from a $150.0 million term loan under a credit agreement entered into by GoodRx, Inc. and various lenders party thereto, or the 2017 Credit Agreement, and cash on hand. In addition, in October 2018, we paid a special dividend to our stockholders in an aggregate amount of $1,167.1 million, and paid accrued dividends to the holders of our convertible preferred stock of $6.4 million. The dividends were financed with net proceeds from GoodRx, Inc.’s First Lien Term Loan Facility and the Second Lien Term Loan Facility, and cash on hand. 6

Valuation Concerns

Another potential reason some companies offer a pre-IPO dividend is because they are worried about the undervaluation of the cash on their balance sheet in an IPO setting. Most investors do not value cash in an IPO company the same way they would in other contexts. The amount of cash on a company’s balance sheet is an important factor in the valuation of any given company, including those preparing to go public. However, in an IPO context, investors perceive a large amount of cash differently. When investors see that a company already has a large amount of cash on the balance sheet, they may question why the company wants to generate capital by going public. Because of this perception from investors, the data show that the marginal value of a dollar in cash has a positive but decreasing marginal value. Simply put, as the amount of cash rises, each additional dollar of cash is valued less. 7 When the value of an additional dollar in cash is less than the value of that dollar paid in a dividend, companies may choose to manage their cash holdings by paying a dividend before going public. In this way, they can provide the greatest possible value shareholders.

Other Considerations

Pre-IPO dividends are a well-documented behavior by many companies. However, the benefit of this behavior changes over time depending on the tax rates for capital gains and dividends. There is less incentive to offer dividends pre-IPO in the situations described above if dividends are taxed more highly than are capital gains. However, these trends change over time. As the tax laws change, the data have shown pre-IPO dividend operating behavior of firms changes as well.

Summary and Conclusion

Companies should carefully consider the implications of paying a pre-IPO dividend because there are a number of risks. Paying out a large amount of cash as a dividend before the IPO may be done to avoid sending the negative signal of early investors cashing out their shares during or after the IPO. However, the dividend payment itself may also send a negative signal to potential shareholders, especially if the motivation for this payment is not clear. Tax laws change over time, creating periods where dividends are less attractive. However, in spite of these risks, the data clearly show that companies see a variety of legitimate, logical reasons that lead them to offer pre-IPO dividends. These include factors such as valuation concerns and prior agreements with private shareholders. When the benefits outweigh the potential risks, offering a pre-IPO dividend is one of the ways a company can provide its investors with a stronger return on their investment.


Footnotes

  1. Martin, J., & Zeckhauser, R. J. (2009). Pre-IPO Dividend Puzzle. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.1484703.
  2. Cone Midstream Partners LP. 17 Sep 2014. Form S-1. Page 58.
  3. asa Systems, Inc. 23 Apr 2018. Form S-1. Page 45.
  4. Burger King Holdings, Inc. 2 May 2006. Form S-1. Page 28.
  5. Burger King Holdings, Inc. 2 May 2006. Form S-1. Page 28.
  6. GoodRx Holdings, Inc. 22 Sep 2020. Form S-1. Page 73.
  7. Martin, J., & Zeckhauser, R. J. (2009). Pre-IPO Dividend Puzzle. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.1484703.
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Author John Baadsgaard

John grew up in Spanish Fork, Utah. In addition to his Strategy degree, he is also completing minors in statistics and economics. John hopes to bring a uniquely down-to-earth, data driven, as well as big-picture perspective to problem solving and analysis. In his spare time, John also loves exploring mountain peaks, cooking exotic foods, and mastering Chopin etudes. He plans to join LEK Consulting in Houston after graduation.

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