Family businesses often depend on two key sources of capital: financial and human. A business exists to manufacture products and/or service customers, and the fruits of that activity are the creation of financial capital. When a business creates financial capital which will not be used in the business, it will distribute this excess capital in the form of dividends to its shareholders. It is critical to make an informed decision about how to use the financial capital that is created. A commitment to reinvest capital and grow shareholder value is also fundamental to both the future of the business and the family who owns the business. Therefore, it is important to align what is best for the business and the family when making decisions for the payment of dividends.
Balancing the financial needs of the business and the family requires planning with the view that the business must continue to produce sustainable profits and cash flow for current and future generations. A fair, well-thought-out dividend policy that includes reinvestment in the business and provides a predictable dividend income stream is important and can be accomplished. Nevertheless, family members must realize that the expectation of ever-expanding dividends is difficult to meet because families often grow at a faster pace than the business. Therefore, the family needs to know and understand that the business will most likely not be able to support them in the lifestyle they’ve been experiencing and alternatives to the business’s current dividend policy may need to be considered.
When Can a Dividend be Considered?
For a dividend to be considered, the company must have an operating profit after taxes. While companies that lose money can pay dividends, they will need to tap into operating reserves and/or borrow. It is also important to understand there are alternatives to dividends available for the cash generated by an operating profit after taxes. Here are two alternatives to consider:
First, activities that contribute to the capital appreciation of the business, such as:
- Repayment of principal on debt
- Working capital to finance growing inventories and accounts receivable
- Replacement of existing inefficient or old capital equipment
- Investment in new capital equipment to support growth
Second, those activities that provide current returns to shareholders such as distributions to shareholders in the form of dividends.
Both alternatives are considered as part of the total return on the investment an owner has in their business. When investments are made in public companies, the total return is based on the appreciation in value plus the dividends received. The same is true with a privately held business, but the difference is there is no public market to ascertain value.
What is the Operating Profit After Taxes?
Operating profit after taxes seems like it would be straightforward, but whether it is depends on the form of business.
- If the business is a C Corporation, it will pay federal and state income taxes on its net earnings. Thus, operating profit will be net of taxes.
- If the business is an S Corporation or Partnership, the net income is taxed on the personal income tax returns of the shareholders, and the company usually makes a distribution to pay these taxes. Thus, for a dividend, net earnings from the company less the distribution paid to the shareholder will be used.
It is important to understand there are tax issues related to these concepts, which are beyond the scope of this article and have not been discussed here.
A Dividend Policy You May Not Realize
Many business owners have a dividend policy and may not realize it. These “effective dividends” are discretionary expenses that are added back to “normalize” income in the event of a sale and to determine the total return.
A few examples include:
- Compensation above the market for similar work. The portion above the market is in effect a dividend.
- Compensation for non-working family members
- Many businesses utilize property they own and rent to the company at amounts above the market for a similar property. The amount above the market is considered a dividend.
- Expenses associated with non-operating assets for the owner’s benefit, such as company-owned vacation homes, aircraft, vehicles for non-working family members, and vacations
Dividend Policy
Every company will have a dividend policy even if the decision is not to pay dividends in cash. A good dividend policy will set future expectations of shareholders while providing the company with sufficient working capital, liquidity to support and sustain the business, and accelerate transferable value. Too often privately held businesses will pay a dividend that will negatively impact the business. Reinvestment in the business is important to support the increasing dividend distribution requirements of the growing number of shareholders; thus, there is a natural conflict that must be reconciled. Although this is not one-size-fits-all, here are a few dividend policy alternatives:
- Fixed Dollar Amount – A specified amount based on a predetermined schedule
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- Fixed Payout Ratio – Utilizes a chosen metric such as earnings, free cash flow, or value and applies a percentage to the metric to arrive at the payout amount
- Smoothing – Like the fixed payout ratio but based on a specific metric using a trailing multi-year average
- Cash Sweep – Distribution equals the amount of excess cash (if any) left after taking care of capital needs
- Special Dividend – A one-time, non-recurring dividend that is usually used when there is excess cash.
When Dividends are Not Enough
A dividend policy may not be enough to satisfy the financial or lifestyle needs of shareholders. As more dividends are paid to support a growing shareholder base, less capital is available to support sustainability for future generations, growth, and the creation of predictable profits and cash flow.
Implementation of a stock redemption plan will provide an alternative to dividends that offers liquidity to shareholders. A stock redemption program gives shareholders the option to sell their shares to the company or other shareholders. It provides the liquidity that certain shareholders desire and reduces the pressure on the business to pay dividends. Pricing is based on a predetermined amount, agreed-upon formula, or annual independent valuation.
A stock redemption can take several forms, such as:
- Annual Redemption Program – This program will allow shareholders who want liquidity to sell their shares to the company or other shareholders at a predetermined value. The company needs to limit the total amount each year so that its own liquidity is not jeopardized.
- Internal Recapitalization – This program allows shareholders to exchange their shares for preferred stock with a fixed dividend. The shareholders who exchange their shares receive the benefit of knowing what their dividend will be, but they do not enjoy an increase in value. This alternative works well with companies that have active and inactive shareholders who need continued cash flow to meet personal needs.
Caution
The unintended consequence of redemptions in a multigenerational business with two or more branches of the family involved is a shift in power and ownership. There could be situations where one branch participates in a redemption program more than the other. The result is conflict.
Final Thoughts
Dividends are part of an overall business and personal financial strategy. The strategic imperative is to balance the capital needs of the business with the liquidity shareholders need to meet their current and future financial asset diversification requirements. Decisions to pay a dividend, what form of dividends to take, or whether to redeem shares require careful financial and business planning.
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