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Did Dr. Dre Outwit Apple At Their Own Game with Beats?

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Steve Pomeranz, CFP

I am a big fan of staying invested in stocks for the long run… but I am also a big fan of diversification… more specifically, diversification of your sources of income and retirement savings. So, for example, while I think everyone should take advantage of 401(k) plans and matching corporate contributions, I don’t want employees to drink in too much of their own company’s Kool Aid and have an excessive position in employer stock beyond vesting and stock options… because you don’t want to get overly dependent on one provider for your paycheck and your 401(k), IRA or other retirement accounts… it’s a lesson many employees at companies such as Enron, Worldcom and Lehman Brothers learnt the hard way when the companies they worked for went bankrupt…. coz poof… within a matter of a few months, they were left with no job, no paycheck and worthless company shares in their retirement accounts… with many employees seeing millions of dollars in paper assets evaporate without their control. So, for example, I think you should take advantage of stock options but diversify your holdings after shares vest by liquidating some of your stock positions and using that cash to buy other stocks… so your portfolio is truly diversified at all times.

Beats $3 Billion Acquisition by Apple

In fact, with the recent release of a movie called Straight Outta Compton that chronicles the story behind gangsta rap group N.W.A, I thought I’d share how Dr. Dre diversified his portfolio after coming into some serious big bucks.  Here’s how it unfolded:

In May 2014, computer giant Apple acquired the critically-acclaimed subscription streaming music service Beats Music, and Beats Electronics which makes the popular Beats headphones, speakers and audio software. Apple acquired the two companies for a total of $3 billion, consisting of a cash purchase price of approximately $2.6 billion and approximately $400 million in shares that would vest over time.

As part of the acquisition, Beats co-founders Jimmy Iovine and Dr. Dre joined Apple.

Today, about 15 months later, Apple is on the defensive while Beats co-founder Dr. Dre is on top of the world. Straight Outta Compton, the movie about Dre’s hip-hop origins is ruling the global box office, having grossed a healthy $170 million so far – more than any music biopic in history with the arguable exception of “The Sound of Music.”

Dre’s first album in 16 years is also running the charts, selling the equivalent of 350,000 copies in three weeks and generating more than 25 million streaming listeners in the process.

And he’s cashing a paycheck from Apple instead of depending on the company’s stock price to hold his net worth up.

Add it all up, and Dre’s financial picture has never looked better. Drill down into the Beats deal and he’s probably done a lot better than Apple stockholders over the last few harrowing market weeks.

Start with the cash

When Dre and partner Jimmy Iovine agreed to sell Beats in the first place, they ended up getting $2.6 billion in cash for themselves and their investors, plus $400 million in Apple stock.

The deal structure and known private equity stakes suggest Dre personally booked about $600 million through the sale, with only about half that amount paid in stock.

At the time, people thought naïve rap stars were cheating themselves by taking so much cash and so little of the hottest stock on the planet. Heck, Apple negotiators probably had something similar in mind: they probably thought padding the deal with dollars from Apple’s cash hoard would let them conserve Treasury Stock – their really valuable currency, and avoid diluting existing shareholders.

But every rapper knows that cash is king when the hammer falls.

The Apple shares that people like current CEO Tim Cook are holding now are about 16.5% lower than recent highs. So if Dre and Iovine had taken their entire payout in Apple stock, they’d probably be agonizing over whether their hard-won fortune was turning back into paper faster than they could get liquid. Throw in the kinds of restrictive covenants that often accompany big share grants – such as 4-year vesting and sale restrictions, and they might have been trapped in their paper fortune with no way to sell or even diversify for months to come.

At best, they could dump their vested shares into a declining market and take a serious haircut while watching their unvested shares take a beating. And depend on Apple’s dividend checks to survive.

But Dre chose cash as a big chunk of his payout and that’s made all the difference. The terms of the deal set aside 5.1 million Apple shares for Beats owners – Dre and Iovine – who are now on Apple’s org chart as senior executives.

And public company records suggest Dre and Iovine haven’t exercised their grants yet, probably because they haven’t been there long enough to vest in the program.

Maybe they just got 25% of their shares to celebrate their first year at Apple. In that case, their paper wealth has only now started accruing.

And in the meantime, they’ve had a year to play with the cash.

Diversify Away From the Source of Your Paycheck

Besides, Dre and Iovine are on the payroll while they’re waiting for the shares to vest. So they’re earning a salary at the company’s expense, enough to give Dre the creative freedom he needs to keep reaching for high-return projects.

So the fundamental issue for Dre is to diversify his overall exposure away from the company that keeps paying his salary.

You get this situation with any highly compensated executive: company stock is highly correlated to the monthly cash flow, so keep the portfolio as far away as possible.

When Dr.Dre gets that stock, it will carry a dividend of $2 per share, so that should deliver passive income of $5 million a year for Dre. Maybe that’s enough to cover his cash flow. Maybe not. But between the paycheck and the dividends, he’s going to be living well.

And if he invested his boatload of cash from the Apple deal, that’s more income. So Dre is better off with his cash and stock deal than if he’d taken the entire payout in Apple stock – because he’s nicely diversified now and has cash in hand to invest or pursue other opportunities… and he wouldn’t have had that option had he gone all stock.

So the lesson here is simple – diversify your sources of income and savings, be aware of stock vesting schedules and sale restrictions, and don’t go all-in with your employer on stocks and savings.

 

I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.