The Lion's Den Vol. 14 - Should Unicorns Start Share Buyback Programs?
With an inflation of unicorns and a drought of exits, private companies might need to get creative to generate shareholder returns
In a recent conversation with a unicorn CEO, he proudly noted that his company had significantly reduced burn and that given how much capital the company raised, it now has a “20-year cash runway”. This made me think - should companies and their shareholders be comfortable with tens and hundreds of millions of dollars just sitting on the sidelines?
This post deals with that exact question and specifically the viability of share buybacks for private companies. In the public market, share buybacks have long been a popular mechanism for returning capital to shareholders. By repurchasing outstanding shares, companies can both distribute cash to shareholders and signal to the market that they are undervalued, potentially enhancing value for remaining shareholders. Buybacks are particularly popular in the technology sector with ~38% of all publicly-traded US companies’ buyback volume according to Verity. With so many mature, well-funded private companies and so few liquidity events, a timely question rises: should private tech companies start buying back shares?
Let’s dive in!
The Backdrop: Endless “Supply” of Unicorns, Narrow Paths to Exit
If you’re a fellow tech investor, I’m sure you will agree that the last ~5 years have been…strange. On one hand, over 1,200 private companies have been “crowned” unicorns in the largest-scale FOMO craze of the 2000’s. On the other hand, the IPO and M&A markets that were supposed to enable large liquidity events have been completely dysfunctional for the past 2 years:
In 2023, there were only three $500M+ IPOs and while 2024 is off to a good start with IPOs like Reddit and Astera Labs, it’s still just a drop in the ocean.
M&A activity in 2023 was at a decade-low driven by high interest rates, a stringent regulatory environment and a general pullback from large deals.
On the other side of that equation are the VCs and growth equity firms that invested in these companies and the LPs that funded them. With VC distributions at a record low, it is no secret that “meeting cash”, otherwise known in the industry as DPI, is a key priority for both LPs and GPs, especially those looking to raise new funds. As a result, and in the absence of a healthy IPO and M&A market, we’ve been seeing a surge of secondary transactions and continuation vehicles of all sorts. Those are perfectly good mechanisms to create liquidity, but more innovative solutions are needed to release the pressure caused by all the capital that is tied up in private, illiquid companies.
Considerations of Share Buybacks by Private Companies
Buying back shares obviously doesn’t make sense for all private companies, but it could for some. Buybacks could be viable for either top-tier companies that can uphold a high valuation through such a transaction or average companies that were funded too richly and have no near-term exit paths. Either way, for this to work companies must be well-funded and on their way to profitability, which is a journey that most tech companies have been on anyway.
Pros:
Liquidity to Shareholders: First and foremost, share buybacks offer liquidity to shareholders (including employees) without necessitating a significant event like an IPO or M&A.
Share Consolidation and Cap Table Simplification: By cancelling purchased shares, remaining shareholders are left with a larger slice of the company. This could be an “antidote” to the dilution caused by previous funding rounds and ongoing ESOP issuance. In addition, unlike secondary deals that introduce new investors to the cap table, share buybacks eliminate the need to accommodate new stakeholders.
Discreet Execution: Share buybacks can be executed internally, with minimal publicity. This aspect is particularly important if the transaction implies a meaningful valuation degradation from previous rounds.
Cons:
Valuation Implication of Buybacks: A low valuation can stir internal unrest, as well as affect the company's 409A valuation and, by extension, employee options. Additionally, details of the transaction could leak externally and affect potential investors’ view of the company. However, those considerations are no different than a secondary transaction or a down-round and should be manageable.
Cash Preservation: In the public realm, a share buyback implies (at least in theory) that a company has excess cash it does not have a great use for and is therefore returning capital to investors. The concept of excess cash will be hard to adopt in a private company setting, especially if the company still burns cash and doesn’t have a clear path to liquidity. For some unicorn companies, cash is the most valuable asset aside from the IP - a share buyback would not be a good idea for those companies.
Reduced Flexibility: These days, many well-funded companies are looking to reignite growth with inorganic efforts, which requires cash. While a buyback will indeed reduce M&A flexibility, I would argue that (1) most of these companies aren’t designed to absorb and integrate large acquisition targets and (2) unless there’s an imminent transaction at play, there’s no point in keeping large cash reserves “just in case”. If a terrific acquisition opportunity presents itself, funding will be there.
As always, I find that quantitative examples help make the point so let’s take a look at a simple financial model for private company buyback. Meet Company A, an illustrative high-flyer back in 2021:
In 2021, Company A received a $150M primary investment at $1.5B post-money valuation.
At the time it had $38M of ARR and was growing 70% Y/Y (i.e. ~39x ARR multiple, not that rare back then) and burning quite a bit of cash.
The company has since slowed down but still grows 30% Y/Y and expects to reach $100M ARR this year
Going forward, Company A will maintain its 30% growth rate for a few years, and will gradually decelerate while becoming profitable.
Based on these assumptions, I would classify Company A as an attractive business, but not one that sticks out as a must-IPO or a must-be-acquired company.
As the table above illustrates, even at a generous 8x ARR multiple, Company A’s valuation would only surpass the previous $1.5B mark in the outer years of the model...So now company A, like many other over-funded unicorns, is at a bit of a crossroad - its early investors would probably make a killing at even half the $1.5B valuation but are completely illiquid while its later investors are probably realizing that this will be a long journey to make a return and aren’t pushing for an exit. This could create a conflict between different shareholders, all while the company is “sitting” on tens of millions of dollars.
Now let’s assume the company enacts a modest $50M buyback at $800M valuation (still a very healthy 8x on 2024E ARR) and mostly cashes out early investors. The quick-and-dirty math looks something like this: Assuming 100M shares for simplicity, $800M valuation implies $8.00/share. This means a $50M transaction would be buying back 6.25M shares such that share count post-buyback is 93.75M. In that case, with some reasonable assumptions on who would sell more vs. less, the cap table might look like this:
Founder gets to sell ~$2.4M of shares and increase his ownership stake by 1.0%. At that same $800M valuation, that additional 1.0% is worth ~$8M - WIN
Angel investor, who probably invested 8-12 years earlier, gets $30M in cash, which most definitely will be an exciting day and gets to keep 22.7% of an $800M company, another $181M of value - WIN
VC investor, who probably invested 6-9 years earlier, gets $13.2M, which likely returns the initial investment, and increases ownership by 0.4%. At $800M valuation, the VC’s 33.4% stake is worth $267M and it’s now all upside - WIN
Veteran employees who vested get $4.4M, giving them some liquidity while maintaining their respective ownership in the company - WIN
Late-Stage Investor has just recently invested and probably won’t sell at the $800M valuation, which means his respective stake increases by 0.7% and he rides this out towards an eventual exit - Not a clear WIN, but maybe worth the effort? Late-stage investors could be convinced to approve the deal if it removes annoying board conflicts and/or if they are somehow compensated for approving the deal (e.g. in down-round M&A scenarios, early investors sometimes share their profits with later-stage investors to get the deal approved)
This illustrative share buyback transaction could be beneficial for the majority of Company A shareholders and after all is said and done, the company would still have a comfortable ~40M cash cushion on the balance sheet.
Conclusion
When maximizing shareholder value is the north star, there should be a balanced discussion about the incremental dollar being allocated to growing the team, investing in sales and marketing, acquiring another business…or buying back shares. Either way, companies should do away with the “20-year cash runway” narrative. It does very little (some would say even hurt) to shareholders returns.
With so many heavily-funded private companies out there, is it time to come up with new, creative return of capital structures?
Onwards!