The issue of whether private companies should pay dividends is an important one. Many private company business owners (and boards) resist paying dividends because they desire to retain flexibility at their companies and do not desire to incur risk from leverage (or slower ability to repay debt). The interesting thing about this position is that it creates polar opposite effects on private companies and their shareholders.
- Impact on company. Not paying a regular dividend can enable companies to repay debt quickly and to accumulate cash and other assets, sometimes substantially so. From one point of view, this reduces enterprise risk, because a company with excess assets and little or no debt may have better ability to work its way through downturns in its industry, the economy or both, than peer companies not similarly situated.
- Impact on shareholders. Assume that three shareholders own 100% of a profitable company in equal amounts, or on-third of the stock each. They collectively retain 100% of the risk of the business. None of the owners has any significant assets outside the business. If it is accumulating excess assets, risk at the company level may be lowered somewhat; however, they retain 100% of the risk of ownership. If something bad happens to the company, and bad things happen to good companies, the owners share in 100% of the downside. If their company loses substantial value due to reverses or goes out of business, they lose 100% of their investments.
The point of this short comparison is that while it may be good to de-risk a business to a point, it may also be a good idea to de-risk its owners over time. I’ve been thinking about private company dividends for a long time. What follows are ten good reasons to consider paying private company dividends and five things that some folks say represent the downside. I hope you find this list interesting and helpful.
In a future post, we will talk about how your company’s dividend policy can be used to maximize the good and minimize the bad aspects of dividends, if they are appropriate in your situation.
10 Good Reasons to Pay Private Company Dividends
Not necessarily in any particular order, here is the list:
- Get unnecessary or excess assets off the balance sheet. Excess cash can be paid to owners in the form of a special dividend, creating one-time opportunities for the shareholders to begin to build liquidity outside their ownership in a business. Removing other non-essential assets, like vacation homes, farms, art collections, and others, may shift value to the other owners, or move the assets into other entities where their impact on the company and the shareholders can be better controlled. One thing experienced transaction advisers know for sure is that it is difficult to get reasonable pricing for non-essential assets in a deal, and it can be very disadvantageous from a tax standpoint to remove them shortly before a transaction.
- Provide all shareholders with regular returns on their investments pro rata to their ownership. Dividends, or after taxes are paid distributions in pass-through entities, are paid pro rata to ownership. A 10% owner gets 10% of the total dividend paid. There can be a perception in private companies that working owners sometimes receive disproportionate benefits (excess salary and perquisites). Dividends do not have that taint.
- Avoid building up excess assets. Regular dividend payments can help avoid the build-up of excess assets when satisfactory returns are not available for reinvestment in a company.
- Maintain reasonable pressure on management for consistent performance. Once a regular dividend is in place, no one wants to be the manager who has to tell the board and owners that it must be cut or eliminated because of poor performance at the company.
- Maintain return on equity (ROE). The payment of dividends, rather than accumulating excess assets, is a means of maintaining a target ROE. The accumulation of excess assets dampens returns for all owners, so dividends help shareholders with current returns and the maintenance of acceptable returns going forward.
- Maintain peace with non-employee shareholders. Regardless of how stock in a company was obtained, through gift or other family transfer, through outright purchase, or other means, minority owners of a business who do not work there can build up substantial resentment for their working relatives or those who are running the company, receiving benefits while doing so, and not paying dividends to all shareholders.
- Provide all owners with a stream of liquidity-creating cash flow and the ability to begin to diversify their portfolios. Readers of this blog know that I am a believer in the idea of diversifying one’s portfolio from exclusive or dominant reliance on an investment in a private company. If reinvested, a steady stream of after-tax dividends can accumulate significantly over a period of years.
- Create a relatively tax-efficient cash flow stream for shareholders of tax pass-through entities. The savings of a layer of taxation with tax pass-through entities makes a dollar of after-tax distributions from them worth a dollar. The equivalent dollar paid from a C corporation is worth a dollar less applicable dividend taxes.
- Reward owners with special dividends if company performance warrants it. Special dividends can be made from excess cash, as noted above. They can also be made upon the sale, for example, of a subsidiary or other asset.
- Enables teaching young shareholders how to manage a stream of dividend income. The existence of a regular dividend stream will let younger owners know that their ownership stakes are real, and should give parents opportunities to work with them to invest their dividends.
So we have ten good reasons to pay dividends if reinvestment opportunities in a company are not sufficient to productively reinvest and grow.
The (Potential) Downside of Private Company Dividends
I’ve heard or thought about some potential downsides to paying private company dividends. In most cases, however, at least in my opinion, these reasons do not override the good reasons above, particularly if reinvestment opportunities are not abundant. So here are five potential downsides to paying private company dividends.
- Paying dividends could, potentially, lead to unrealistic shareholder expectations. Once on the narcotic, so the thought goes, it is hard to get off, and easy to always be asking for more.
- There can be a strain on cash flow if shareholders demand higher dividends (or the maintenance of the dividend in a downturn year). No one likes to cut a dividend, but many boards have had to do so at one time or another. Dividend policy is just that. It has to balance the needs of the company and the owners.
- Some folks argue that dividends, even distributions from pass-through entities, are tax-inefficient. There are worse things in life than paying taxes.
- It might lead to shareholder dissatisfaction if it is necessary to cut or eliminate the dividend. This is a second take on #2 above.
- Rigid adherence to a strict dividend policy could preclude the availability of internal capital for good or great investment opportunities. One objective of a good dividend policy is to provide the flexibility for change if needed, particularly in the private company context.
So there we have it — Some pretty good reasons for private companies to pay dividends to their owners — and some reasons to think about that could have some downside.
We will look at the whole matter of dividend policy for private companies in subsequent posts.
And for Some Reading
My book, Unlocking Private Company Wealth, has two chapters on the topic of private company dividends. It is available with my Buy-Sell Agreements for Closely Held and Family Business Owners in a bundle for only $35 (plus s/h) in what we call the Ownership Transition Bundle, which also comes with additional free resources.
I hope you are enjoying this blog. Feel free to comment below or to me directly.
Until next time,