Dividends and dividend policy are topics that have been highly popular on this blog. In today’s post, we’ll look at a hypothetical situation at a closely held or family business and discuss the concept of the special dividend. Before looking at the hypothetical, let’s define the term.
What is a Special Dividend?
We can define a special dividend as a distribution of company assets, usually cash, that is in addition to a normal dividend. If dividends are not being paid, a special dividend might be a one-time event. Special dividends can provide liquidity to shareholders and enhance a company’s return on equity. Special dividends are sometimes paid by public companies after a period of excellent performance to reward shareholders without changing the normal dividend policy.
Public companies tend to hire lots of MBAs who are well-versed in corporate finance theory and practice. Their managements and boards are exposed to public securities analysts and institutional investors who are also familiar with corporate finance. Many, if not most, private companies don’t think in terms of corporate finance in the way that public participants do. But the same rules of value creation and shareholder returns apply in both the public and private markets.
A Hypothetical Private Company
The following word picture describes a hypothetical private company. The description may resemble one or more companies in an attorney’s client base, or the client bases of financial planners, accountants, business appraisers and other professionals. If you are a business owner, your company could resemble this hypothetical in one or more ways. In any event, read this word picture and think about your clients’ situations, that of their companies, and of their other shareholders, whether they are family members or not.
- The company has been successful over a period of several or many years.
- The company has never paid dividends. If the company is a pass-through entity, it has likely never made distributions other than for owner tax liabilities. If the company has paid dividends or economic distributions (above taxes), they have likely been irregular or stingy or both.
- Cash is accumulating on the balance sheet as result of successful operations and a lack of good reinvestment opportunities and/or debt is being reduced.
- Bankers are quite interested in loaning money — after all, the company doesn’t need it!
- Management may be looking for a significant investment opportunity, which is one reason for accumulating cash, but things are pricey and there is a need to be choosy. The bottom line is that large acquisitions are risky and management will be sure to take its time. In the meantime, the cash machine keeps on running.
- As deleveraging occurs, the company’s return on equity is decreasing. That means that shareholders’ returns are decreasing and continue to be deferred.
- The owners have had the philosophy of keeping all of their eggs in the company’s basket and watching that basket very closely. As a result, the shareholders have most of your collective net worth tied up in the company. This philosophy has worked for years, so why change now? Well, read on.
- Things have gone well for a long time, and the owners don’t feel there are significant risks to the business. In the alternative, they are so accustomed to doing things the same way that inertia has set in. Unfortunately, the owners are probably wrong about the risk assessment. Bad things can happen to even really good companies. And when bad things happen unexpectedly, the picture changes and options are diminished, often drastically. There is a reason why financial planners admonish their clients to diversify their wealth.
- But still, the controlling owner doesn’t want the kids to receive a windfall, or for goodness sake, those nonworking owners don’t deserve anything. However, the controlling owner(s) cannot control everything, and they are the custodians charged to deliver satisfactory returns to all of shareholders.
- The owners are vaguely aware that special dividends are paid by some public companies, but somehow they think that their motivations are not relevant for them and their private company. They are.
This hypothetical description of a private company is really not so hypothetical at all. It resembles a growing number of private companies that I, and other professionals, see.
If the word picture painted above fits the circumstances at one or more of your clients (or your own company), let me recommend that you talk to your clients about implementing a special dividend this year. The rules of corporate finance apply to private businesses as well as public companies. If adequate growth opportunities are lacking, a company’s best “investment” may be a special dividend to its shareholders.
Some companies could pay a dividend equivalent to 10%, 20%, or even 30% of their current market values. They have accumulated substantial excess assets. The ability to pay will depend on the current balance sheet position, relationships with banks, and the own ability to think outside the historical box that has helped the owners become so successful. Perhaps now is the time to give it a try.
And don’t worry about the value of the business going down following the special dividend. Even if it did go down dollar for dollar, the owners have traded a dollar of illiquid wealth for a dollar of liquid wealth (less a bit of tax). The diversification opportunity is worth the tax bite from the dividend.
Please do get appropriate tax, legal and financial advice!
Do Something Now
Call me or a trusted financial adviser today. Ask your clients’ financial planners what they think about a little diversification.
Read Unlocking Private Company Wealth. I wrote it. Chapters 8 and 9 address dividends, including special dividends, and dividend policy. Here is a short excerpt from Chapter 8:
Special dividends, to the extent that your company has excess assets, can enhance personal liquidity and diversification. They can also help increase ongoing shareholder returns. I have always been against retaining significant excess assets on company balance sheets because of their negative effect on shareholder returns and their adverse psychological impact. It is too easy for management to get “comfortable” with a bloated balance sheet.
If your business has excess assets, consider paying a special dividend. Your shareholders will appreciate it.
Don’t look back a year from now and think that you didn’t do anything wrong by not working with your clients to suggest paying special dividends where warranted. Not doing something, in future retrospect, could well have been the wrong thing.
My two most recent books are available in an Ownership Transition Bundle. The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers and attorneys.