We the Family: The Benefits of Creating a Family Constitution

We are often asked by family business owners looking to develop a dividend policy for the best formula to apply.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 varying needs of shareholders and the overall capital requirements of the business. 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.2 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 paid by the company. This approach obviously 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 because the number of shareholders increases, as does 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 rather than 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 it is decided that dividends should be paid, it becomes more practical to institute a system that provides transparency and predictability to owners. While dividends can be an effective way to provide liquidity to shareholders, 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.

Outlining a dividend policy without first analyzing the company’s needs might result in an impractical policy that is unsustainable or not in the best long-term interest of shareholders and the company. Ultimately, the capital allocation policy should 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.3

For owners that have gone through the capital allocation exercise and are committed to formalizing a dividend policy, this article outlines five options. The choice of policy should be informed by shareholder priorities and specifics for each business.

Common Dividend Policies

Fixed Dollar Amount
A fixed dollar dividend is the distribution of a specified dollar amount by the company 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. This policy is most commonly used by more mature companies with stable earnings and steady cash flow, although a company can create a reserve that allows it to pay a fixed 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 dividends for yearly expenses.

In theory, fixed payments may be adjusted, but they tend to be “sticky upward.” There is high shareholder pressure to maintain dividends at or above the fixed amount, forcing the company in some cases to maintain cash reserves or even borrow for an inevitable downturn in the market and limiting management from allocating these resources elsewhere. Additionally, if the dividend is too high, 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, it is management’s responsibility to plan for good and bad years for the business.

Fixed Payout Ratio
Under a fixed payout ratio policy, the company chooses a metric, such as earnings or free cash flow, and applies the same percentage value to that metric to arrive at the payout amount to shareholders. 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 for the company, 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 dividends and more uncertainty for shareholders. As such, this policy is not as suitable for shareholders that prefer more predictable liquidity streams.

We the Family: The Benefits of Creating a Family Constitution

Smoothing
Like the fixed payout ratio method, the smoothing method is based on a specific metric (for example, free cash flow), but the payout ratio is typically calculated as a percentage of a trailing multiyear average. For example, a company may choose to 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 for 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 performance in past years – 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 that want to grow the business 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. Special dividends may also be distributed following a period of particularly strong performance during which cash has accumulated. Special dividends provide flexibility as to when and why they can be made and have great potential to enhance liquidity and wealth diversification of shareowners. 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 – which method is used and why, what the future expectations are, and so forth – is just as important as the policy itself. 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 an overarching capital allocation policy for the business will be able to stack hands on a dividend policy that best meets the goals of the owners and enables the business to thrive in the long term.

We the Family: The Benefits of Creating a Family Constitution

 

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1 Dividends refer to cash returned to shareholders. In the context of a family-owned business and for the purpose of this article, this is further qualified as distributions above and beyond that required to cover taxes in pass-through entities.
2 For more on the process of allocating capital in a private business, read our second quarter 2016 Owner to Owner article, “Capital Allocation for Private Business Owners.”
3 For more on the delicate balance of managing capital and liquidity demands, read our third quarter 2017 Owner to Owner article, “Balancing Business Reinvestment and Shareholder Liquidity Needs in a Multigenerational Family Business.”