Two standard questions business appraisers ask clients in the management interview process include:
- What has been your dividend (or distribution) policy leading to the present? Now this is something of a trick question, because we can infer what the dividend policy has been in the past based on examining financial statements.
- What do you expect your dividend policy to be on a going-forward basis? The answer to this question can have an impact on minority interest cash flows and, therefore, on value of illiquid, minority interests.
We Don’t Have a Dividend Policy
One fairly common response from business owners is: “We don’t have a dividend policy.” When I hear this response, it always prompts a good discussion, because I’ll respond that every company has a dividend policy. It is just a matter of figuring out what is it or is expected to be.
Owners respond by saying something like, “We don’t pay a dividend. In fact, we’ve never paid a dividend. So how can we have a dividend policy?”
Most will grudgingly admit that even not paying a dividend is a form of policy when that “policy” is exercised over time.
11 Potential Dividend Policies
There are a number of potential dividend or distribution policies that are employed by private companies. The following list, with brief comments, is perhaps not all-inclusive. If you have other examples, please comment below or contact me directly.
- No dividend is paid at all. Hopefully, companies that pay no dividends are experiencing attractive reinvestment opportunities. By definition, a dollar not paid in dividends is reinvested in a company.
- For tax pass-through entities, distribute enough so that shareholders/members/partners can pay their pro rata share of pass-through taxes. Almost all pass-through entities distribute sufficient earnings so that their owners can pay their taxes.
- One-time dividend. A dividend is paid at a point in time for reasons that are applicable at the time of payment, but no further dividends are expected.
- Special dividend(s). A special dividend could be a one-time thing, but some companies will pay an occasional special dividend for reasons that are applicable at the times of payment.
- Constant dollar dividend. I’ve seen a number of companies that started paying a dividend at a specific dollar amount and then continued to pay that same dollar dividend each year for many years.
- Target dividend payout ratio. A company may set a target dividend payout ratio of, say, 35% of after-tax earnings. Then, the dividend would vary from year to year as earnings increase (or decrease).
- Dividend yield target. The dividend yield relates the dollars of dividends paid to the value of a business. One company we valued for years set its dividend yield target at 3.0% of the concluded value of our appraisal. The dividend for the current year was paid shortly after the appraisal for the last year was received.
- Residual dividend policy. Some companies focus on reinvestment opportunities. If sufficient attractive reinvestment projects are not available in a given year, the residual net income that is not reinvested is paid out as a dividend.
- Spin-out or spin-off of subsidiaries or assets. Company strategies change over time. If a particular subsidiary (or asset) no longer fits with the business mission, one way to address the issue is to spin it out to owners who can then address the subsidiary (or asset) independently of the company. Public companies have used this technique for years, creating additional public companies with each spin-off.
- Regular dividend supplemented by an occasional special dividend. Interestingly, there were 14 companies in the S&P 500 who paid a regular dividend and then paid an additional, special dividend during the year. This way, owners can expect the regular dividend, and there is no commitment or obligation on the part of the company to continue to pay the special dividend.
- Pay incremental, above-market, bonuses to selected owners who run a business. This is a subtle form of dividend policy. Owners who make discretionary payments to themselves may be paying non pro rata dividends to the extent that they are above-market level payments. But all owners should understand that such discretionary payments are, in fact, part of the distributable earnings of a business.
Every company does indeed have a dividend policy. What is your company’s policy?
Please do let me know if you think of any other variations on private company dividend policies.
In the meantime, be well!