Family business owners often ask us about the best formula to apply when developing a dividend policy.1 Unfortunately, it is not that easy. Dividends play an important role in rewarding shareholders but must be viewed in the broader context of the shareholders’ various needs and the business’s overall capital requirements.
For any company, the right dividend policy marries the needs of its shareholders with what the business can support based on its operations. There is no one-size-fits-all dividend policy for privately held companies – dividends are one part of a capital allocation strategy to maximize shareholder value. What is right for your family business depends on many factors.
Not every company has to issue dividends. Smaller shareholder bases, with true owner-operator dynamics, tend to prioritize business reinvestment over dividends to grow and drive shareholder value. These owner-operators generally have more flexibility to provide liquidity for themselves and other owners through other means such as salary, incentive compensation, and other discretionary expenses the company pays. This approach becomes more challenging as the number of shareholders increases.
As the control and leadership of a family-owned business transitions to the second and third generations, the desire for liquidity may grow as a result of the rising number of shareholders – and at the same time, the size of the inactive shareholder group. This inactive shareholder group, typically minority owners, may view themselves more as investors entitled to a tangible nearer-term return. They often don’t think of themselves as owners active in management striving to increase equity value in the long term. This places pressure on the business to pay dividends or pursue other liquidity options (for example, a share repurchase program, company-sponsored loan program, recapitalization, or sale of the business).
Over time, if the business decides it should pay dividends, it becomes more practical to institute a system that provides transparency and predictability to owners. While businesses can provide liquidity to shareholders in the form of dividends, it is important to note that dividends are not tax-efficient for both the company and shareholders. At the corporate level, dividends are paid from after-tax earnings. At the shareholder level, dividends are taxed as ordinary income rather than at lower capital gains rates.
When outlining a dividend policy, a company should first analyze its needs. Failing to do so might result in an impractical, unsustainable policy or one that is not in the best long-term interest of shareholders and the company. The capital allocation policy should ultimately align with the company’s strategic vision. Reinvesting in the business and providing liquidity to shareholders are not mutually exclusive – both are often necessary for success.
Here, we outline five options for owners that have gone through the capital allocation exercise and are committed to formalizing a dividend policy. Shareholder priorities and specifics for each business should inform the choice of policy.
Common Dividend Policies
Fixed Dollar Amount
A fixed dollar dividend is the company’s distribution of a specified dollar amount of dividends according to a predetermined schedule (such as quarterly or annually). This policy provides shareholders with a consistent source of liquidity, which tends to build confidence among shareholders.
While most commonly used by more mature companies with stable earnings and steady cash flow, a company can also create a reserve that allows it to pay a fixed, stable dividend even when earnings are low, or there are losses. Given this predictability, it is favored by a shareholder base (for instance, retirees or widows/widowers) that relies on regular dividends for yearly expenses.
In theory, fixed payments may be adjusted but tend to be “sticky upward.” There is high shareholder pressure to maintain dividends at or above the fixed amount. In some cases, this forces the company to maintain cash reserves or even borrow for an inevitable market downturn and limits management from allocating these resources elsewhere.
In addition, suppose the dividend is too high. In that case, it can siphon a company’s cash and prevent or delay necessary investments in the business, which could impede a company’s ability to thrive in the longer term. When considering a fixed annual dividend, management must plan for good and bad years for the business.
Fixed Payout Ratio
Under a fixed or constant payout ratio policy, the business chooses a metric, such as company earnings or free cash flow. It applies the same percentage value to that metric to arrive at the payout amount to shareholders. For instance, a company could distribute a fixed percentage of profits or percentage of retained earnings. This policy offers the most flexibility to account for the type of business/industry and shareholder expectations.
Using a ratio, as opposed to a fixed dollar amount, means that the payout is determined by a company’s performance in any given year. When the company is not performing well, shareholders will receive a smaller dividend (if any); in a strong year, shareholders will receive a larger dividend payout.
Payout ratio policies do not necessitate maintaining liquid reserves since dividends are a function of how much cash is available to be distributed.
While this policy is flexible and prioritizes business needs, particularly in years or periods of underperformance, it can lead to inconsistent or irregular dividends and more shareholder uncertainty. As such, this policy is unsuitable for shareholders that prefer more predictable liquidity streams.
Smoothing
Like the fixed payout ratio method, the smoothing method is based on a specific metric (for example, free cash flow). Still, the payout ratio is typically calculated as a percentage of a trailing multiyear average. For example, a company may set its annual dividend at 10% of the average of the last three years’ earnings. Using a multiyear average removes the extremes of outlier years, either positive or negative. This method allows dividend payouts to be more consistent year over year while generally trending with business performance.
The strength of the policy is also one of its weaknesses – shareholders may be upset by the lagged response of dividend payouts to business growth. The smoothing method is also more difficult to change once implemented, given its dependence on the company’s past performance. Tenured shareholders who have had to exercise patience may not be as willing to appease impatient new shareholders. Shareholders of companies with large earnings swings will naturally experience more dividend volatility than firms with consistent cash flow.
Cash Sweep
With a cash sweep or “residual” dividend policy, the distribution is equal to the amount of excess cash (if any) that is left after taking care of the business’s capital needs. This approach is a business-friendly policy that prioritizes reinvestment over short-term shareholder liquidity and is good for companies wanting to grow or pay off debt. It prioritizes corporate uses of cash and naturally allows distributing excess cash when high returns on investment opportunities for the business are not available.
A cash sweep policy allows the company to sidestep having to pay dividends in down years, but also avoids the accumulation of funds during good years. This policy tends to work best for more concentrated shareholder groups who are aligned on prioritizing business needs over providing liquidity to shareholders.
One downside of a cash sweep policy is that dividends may vary greatly depending on annual free cash flow generation and business needs. As near-term shareholder needs are given the lowest priority, shareholders might have to wait for an extended period before they receive a dividend payment.
Special Dividend
A special dividend is a one-off payment to shareholders. It is a more extreme version of the cash sweep method except that special dividends are not recurring – there is no requirement to provide liquidity, and the company may choose to simply accumulate cash on its balance sheet. For example, some companies may pay a one-off special dividend due to a major event, such as a recapitalization or business reorganization. Businesses may also decide to distribute special dividends following a period of particularly strong performance during which cash has accumulated.
Shareowners have an opportunity to enhance liquidity and diversify wealth with the flexibility of special dividends. This type of policy is typically used by shareholders that are not reliant on dividends as a sole source of income or by companies operating in cyclical industries.
This policy may lead to shareholder impatience since the distribution is unpredictable, but when it is paid, it may signal that the company has a lack of future investment opportunities.
Conclusion
Whether or not an owner realizes it, every company has a dividend policy – even the decision not to pay dividends is a policy! As is the case with most decisions for privately held (and particularly family-owned) businesses, communication and transparency regarding the dividend policy is just as important as the policy itself. Information such as the type of dividend used and why, future expectations, and so forth is critical to share with shareholders.
Effective dividend policies are flexible enough to respond to economic and business cycles yet firm enough to manage shareholder expectations. Well-informed shareholders who are aligned on the business’s overarching capital allocation policy will be able to unite around a dividend policy that best meets the owners’ goals and enables the business to thrive long term.
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