Why Share Repurchases Create Large Opportunity Costs for Early Stage Startups

This post is by Tomasz Tunguz from Tomasz Tunguz

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In the public stock market, share repurchases/buybacks have reached more than $1 trillion in 2018, a historic high. As the amount of private capital increases, share repurchases in startups are popping up. Typically, they are a very inefficient use of capital.

A share repurchase occurs when the company uses cash on its balance sheet to buy shares from an existing shareholder, typically an employee or an early investor.

For public companies, buying shares is a way of using excess capital to increase the earnings per share (EPS) and other metrics that investors care about.

For startups, EPS isn’t a concern and cash is very expensive. Every dollar on the balance sheet dilutes shareholders, assuming the business is venture funded and unprofitable.

If the business is a fast growing SaaS company, then each dollar invested to grow revenue increases the revenue of the company substantially. But a dollar invested to back a share increases the value of a business by a scintilla.

Here’s how the math works. Assume a company sits at a $30M post money. Assume the company would like to repurchase 1% of common equity for about $300k. The number of outstanding shares has been reduced by 1%, so the price per share increases by 1.01%.

Let’s compare to investing in the business. Assume the company used the $300k to hire two account executives at $150k OTE (on-target earnings) each with a $600k quota. Assume 60% quota attainment. In 12 months, these AEs have produced $720k in combined new ARR bolstering the valuation of the company by $7.2M. That’s a 250x better ROI that the share repurchase – quite a difference.

There are reasons to pursue share repurchases. But when evaluating them, consider the significant opportunity cost of investing those dollars into the business, especially in the early stages of a company.

NB: These types of buybacks differ from a share repurchase as part of a secondary transaction. With many large later stage rounds, new investors would like to own as much of the company as possible and accomplish this goal by buying shares from early employees because the company doesn’t want to bear more dilution than necessary.

Because new investors ask for preferred shares and employees typically hold common, often these secondaries are structured as share repurchases. The investor gives money to the company, the company buys the shares from the common holders, retires the common shares, and creates new preferred shares in the same amount.

There are downsides to this type of transaction as well, including increasing the depth preference stack (total value of preferred shares), without increasing the balance sheet of the company.

Photo by John Cobb on Unsplash