Over the last several years we have reviewed nearly one-thousand private companies. A handful held marketable securities. In each case I believe it was the result of a restricted dividend policy. The family business wanted to hold on to more current assets than were immediately required in the business and rather than sit on cash they began to purchase CD’s, bonds and publicly traded stock. Was this wrong?
Most closely held businesses are managed according to the goals of the individual owners. The distinction of the owner and her property inside and outside the company is often blurred. This is as it should be. The asset is subject to the owner’s direction, and if she is both the owner and the manager, she can allocate her property in accordance with her beliefs about the future.
If immediate distribution of cash to the owner is not desired by the owner then what difference does it make if she holds it inside the company or outside? Are the risks higher or lower in each? What of taxes? These are each unique and complex decisions. So, I’ll say, “it depends.”
The more interesting question to ask yourself is not whether or not it is right or wrong, but for what purpose does it serve? Does it help achieve the mission of the business? Of the owner?
At Little Engine Ventures we take in partner equity in the form of cash on an upfront basis. We do not raise cash on a deal by deal basis. For partners this distinction is simple and clear. It also aligns with our purpose: “Be the best alternative to our partner’s primary business.” We accomplish this by taking on the burden of allocation. And, we take it on entirely, right up front, for all they want to put at risk with us.
Once we have the cash in hand we cannot (and should not) immediately purchase the very next private business we inspect. Rather, we should weigh our alternatives in rank-sorted order, from best to least. Do we have a margin of safety in our best idea? Can we buy more of it now? If so, we ought to transform our cash into productive equity.
Little Engine Ventures is built upon lots of small, fractal blocks of business equity. Mikel calls this “smaller working units.” With smaller units we can ebb and flow resources with more fluidity. Acquiring lots of small businesses helps us retain this procedure while extracting both control and liquidity premiums. However, in the absence of quality control ideas we should not become illiquid out of hope alone. It ought to serve a purpose.
We are generalists. We go wherever our circle of competence allows. This freedom, autonomy, independence and exploration are the primary reasons I do what I do. We probably could gather a lot more assets more quickly if I promised to fit into some archetype. But I refuse. I refuse out of principle and purpose. My purpose is not to have the largest fund, but to be the best alternative to our partner’s primary business. How does limiting my partner’s universe improve their odds of their success? Are they not trusting me to discern a good deal or not?
Given the go-anywhere-for-my-partners-benefit mantra, I often find myself with lumpy distribution of cash and unmarketable private company interests. Sometimes I say, we ebb out and flow back. Other times, I say we slosh from one side to the other of our current assets and our long term assets, and from long term assets back to current.
Formulaically, I strive to extract a 6% liquidity premium for a long term, private interest holding. If I can achieve a similar return (let’s say 15%) inside a marketable, highly liquid ownership position, why should I accept a 17% return from an illiquid interest? The gap is not great enough to pay for the risk. I like my comfortable seat that is easily and quickly traded. As such, I believe marketable securities are worth consideration. I also think you can compare these companies with your own private company ideas.
The other synergistic effect we enjoy –I hate the word synergy– is the stark comparison between large, established and well-run public companies with the tiny, young, fragile private company universe. I love reading about business. Each public company is like a little investigative journalistic enterprise for me. I scan for interesting stories, or simply things I am fascinated by. As I find something intriguing, an idea, or a thesis, I begin studying everything I can on the subject. Many times I study things that are bad ideas. What caused them to do this or that? In both cases, I create notecards for each company and record my findings. I write little narratives. I follow a theme but I also allow discovery to guide my investigation. I go down this or that trail to find a dead end, or perhaps some little nugget. I turn over rocks and ask questions. I do it for the sheer joy of learning. I discover and learn. I figure that the worst thing that happens is I have more ideas and experiences to draw from. I wasted my time. But, who is paying me for my time anyways? I am paid for the realization of my ideas acted upon. So I ask questions of myself, like, ‘How can I position our little roll off dumpster company relative to Waste Management and Republic Services?’ What do they do or have that we cannot? What can we do that they cannot? I can merge this macro storyline with what I and teammates see on the ground from our little office in Tipton, Indiana. I’m not dictating what happens to the manager, but I am compounding my knowledge in a way that informs my questions, that I ask, as the owner.
(we don’t own any Waste Management or Republic stock today, nor do we intend to take any position in the foreseeable future.)
The vast majority of the time we do not acquire marketable securities in the industries in which we already have control positions. Instead, I try to counter-balance our industry risk with non-correlated investments elsewhere. This can be hard at times, because I like to buy things that are out of favor, and they tend to go out of favor together. That said, there are certain things like bank stocks that are much easier to own publicly than privately. We have also owned fractional interests in public companies that we would acquire the whole of should our bankroll allow. A number of times thus far, these gems are acquired by larger buyers and we are rewarded for my research and early, swift action.
There are occasional desires on my part to pull the second string on this marketable security bow. Thankfully, since launch, my colleagues have reminded me to stay true to our rank-sort process. They challenge me on the intrinsic value and the frictional cost to take control of a little public company. I appreciate that. It is good to be reminded of your principles by those whom share your beliefs.
If you believe in buying assets for less than they are worth, doing the work, or employing the managers to oversee your interests, I highly recommend you consider marketable securities in your private company. You do not need to hold gobs of names. You do not need to allocate hours of time. You could buy the index or even pick five names you like and buy them equally. Do not create excess work for yourself just to heed my advice. I am no advisor. I am a practitioner.
If you are a practitioner too then why would you not consider owning some of the best companies on the planet when they trade below the price a well informed private buyer would buy the entirety?