Corporate finance can be confusing if you are a private company.  Much of what we think about comes, directly or indirectly, from corporate finance ideas and concepts developed around the public markets.  This post looks at what is called the Modigliani-Miller theorem, makes a few observations, and then, attempts to relate them to closely held and family businesses, i.e., the private company world.  The Modigliani-Miller (M-M) theorem forms the basis for much current thinking about capital structure and related thinking about the efficacy of the payment of dividends by companies. In the real world where private companies operate, the assumptions of the M-M world often do not hold.  So what should private companies do about their dividend policy? Let’s see… The Modigliani-Miller (M-M) theorem relates to and influences much current thinking about the capital structure of businesses. The theorem makes certain restrictive assumptions in reaching its primary conclusions, including:

1. Markets are efficient
2. There are no taxes
3. There are no transaction costs
4. There are no bankruptcy costs
5. There are no agency costs, so managers are always working to further the interests of stockholders
6. No one holds asymmetric information, which might provide advantage to one side or the other in transactions
7. Stockholders are indifferent between receiving returns in the form of capital gains or appreciation (because they can sell at any time without cost or friction)

There is another implicit assumption in the M-M world.  Companies can always reinvest all earnings back into the business and achieve the required return on capital.  This, as it turns out, is an important assumption when we look at the world of private companies. Under these assumptions, the M-M theorem reaches these two influential conclusions:

• The value of a business is unaffected by how it is financed.  It can be financed with all equity or varying portions of equity and debt, but the value of the firm is the same, regardless. This is intuitively attractive, since we often look at company values on a total capital basis.  Assume a company is worth a multiple of 6.0x EBITDA of $10.0 million.  The market value of total capital (MVTC) is $60 million, and it doesn’t matter how much is financed with equity or debt.
• Investors are indifferent between receiving returns in the form of dividends or capital appreciation.  So, according to M-M, dividend policy doesn’t matter and is essentially irrelevant to firm value.

I’ve been working with private companies for more than 30 years and I’ve long thought that dividend policy is important for them. Three recent posts address some of my thoughts:

• Dividends and Dividend Policy for Private Companies – An Introduction
• Dividends and Dividend Policy for Private Companies – 7 Critical Things You Need to Know About Your Company’s Dividend Policy
• Dividend Policy and 5 Reasons NOT to keep Non-Operating Assets on Your Balance Sheet

Modigliani-Miller vs. the Real World Let’s look at the M-M assumptions above as they relate to the real world of doing business in a private company.

1. M-M assumes that the public stock markets are efficient.   Stocks always sell at their “fair values” on stock exchanges, so it isn’t possible to purchase undervalued stocks or to sell for inflated prices.  Higher returns are a function of embracing higher risks. However, in the world of private companies, there are differences. The market for private companies is hardly efficient. Markets exist, but it is difficult and time-consuming to sell whole companies.
2. There are no taxes.  Benjamin Franklin said, “In this world nothing can be said to be certain, except death and taxes.” Private businesses pay income taxes at the state and federal level, and their owners pay taxes on distributions.  They also pay capital gains taxes on the sale of appreciated stock.  The existence of taxes is real and the absolute level of taxes as well as the relationship between taxes (i.e., between dividend taxes and capital gains taxes) affect the way private company investors think.
3. There are no transaction costs.  We do not live in a world where transaction costs are nonexistent. Different kinds of transactions have different costs, so private company investors must think about transaction costs.
4. There are no bankruptcy costs.  If you’ve ever been involved in a corporate bankruptcy in any role, you know that bankruptcy costs are real. Bankruptcy is something to be avoided in private (or public) businesses. Companies may want to protect themselves from the prospects of bankruptcy, and may retain excess capital as a cushion. But this bankruptcy protection is not free in that it bears the costs of foregone returns.
5. No agency costs.  In private businesses, the key managers are often the key owners, so the issue of agency costs can become murky. When there are differences in the relative ownership of a business and in the relative “manager-ship” of the business, i.e., where some owners may not work in the business, agency costs can certainly be present in a private business.
6. No asymmetric information.  In  public companies, management always knows things that investors don’t know, even if only in terms of timing. In private companies, insiders most often have information about the business not held by non-working shareholders. Occasionally, perhaps, the inside owners will use that information to the detriment of the outside owners. This can be implicitly or explicitly, intentionally or unintentionally.
7. Indifference between dividends and capital gains.  In theory, public shareholders could be indifferent between dividends or capital gains, given equivalent taxes on the two forms of returns.  However, even investors in public companies are often reluctant to sell portions of their stakes to obtain liquidity, so they might prefer dividends. In private companies, there are inside owner-managers, and outside owners whose interests may not be well-aligned at all.  So shareholders of private companies bay be anything but indifferent regarding the form of returns. Outside owners often desire dividends, particularly if the inside owners/managers might attempt to acquire shares at discounted prices because of their “minority interest” nature.

Capital Structure Matters for Private Companies M-M may suggest that capital structure doesn’t matter and that the value of the firm remains the same, regardless of the allocation of financing between equity and debt. If you’ve ever been an owner-manager of a private company and engaged in a significant financing event for your business, you may well know that capital structure matters – if only to your bank!  You know this in particular if you’ve ever had to sign a personal guaranty for a corporate loan. In the M-M world, bankruptcy costs may be zero, but in the real world, bankruptcy costs are potentially very high for your bank and for your owners. This doesn’t mean that there should be a strong aversion to debt financing in private companies, but only a healthy respect. Capital structure combined with profitability provide the potential for the returns for investors in private companies.  In today’s low-cost debt environment, returns to shareholders can be significantly enhanced in many companies by the judicious use of financial leverage.  Recent posts on the topic of leveraged share repurchases may be interesting.

• Leveraged Share Repurchases (Buy-Backs): An Illustrative Example
• Corporate Finance for Private Companies: A Leveraged Repurchase

Private companies need to be intentional about their capital structure. The ultimate returns achieved by shareholders will be influenced and perhaps strongly influenced, by each company’s decisions regarding financing, both of the business and of leveraged share repurchases or dividends if appropriate. Dividends (and Dividend Policy) Matter for Private Companies and Their Owners Your company’s dividend policy is the throttle that determines the portion of your shareholders’ returns will be in the form of current dividend income and what portion will be deferred.  Your company’s dividend policy determines or helps influence the capital structure of your business.  And your company’s dividend policy has a direct influence on the rate of return that will be achieved by your shareholders on their investments in it. Think about these situations from my memory bank:

• One Shareholder.  One shareholder owns 100% of a profitable business.  For a variety of reasons, he does not want to pay dividends from the company. As a result, the company accumulates a growing hoard of low-yielding cash assets.  This continues over a number of years.  By not paying dividends and allowing the growth of non-operating cash, he has dampened his overall return over the period.  He would be better off financially to pay dividends and taxes on dividends, reinvest in liquid assets outside the business, and allow the business to have a more reasonable capital structure and to achieve better overall returns (for him).
• 3 Shareholders.  A company has three owners, two of which work in the business and control, between them, 80% of the stock.  The inside owner-managers earn substantial salaries and are not interested in paying dividends.  The outside shareholder receives little or no current return on his investment.  The outside owner is keenly interested in an appropriate dividend policy for this business.
• Multi-generational Family Business.  In a multi-generational family business there are many potentially competing interests regarding dividend policy.  The first generation owners who are retired are interested in dividends.  The second generation owners, who run the business, are less interested in dividends.  And the third generation owners, the kids of the current second generation owners, have no influence on the business or dividend policy.  Regardless, their interests may be best served if dividends are paid.

The point is, with divergent interests on the part of different shareholders, dividend policy is an important tool to balance the various interests for the good of owners and companies. Wrap-Up This post is certainly not critical of the Modigliani-Miller theorem. Their work has driven much progress in the field of corporate finance. However, we cannot blindly assume that all of the assumptions of the M-M theorem hold in the real world of private company finance. Capital structure influences the level of shareholder returns to equity over time. Dividend policy determines the current returns to owners over time. The combination of a reasonable capital structure, a reasonable dividend policy, and paying attention to the needs of various owners make real differences in the long-term success of many private companies. My new book, Unlocking Private Company Wealth, will be available in a few weeks.  If you want to be notified when it is available, please sign up at the upper right portion of this blog.  Please do sign up to receive future posts by email, as well. Call me (901-685-2120) or email me (mercerc@mercercapital.com) if you would like to talk about your company’s capital structure and dividend policy, or to talk about ownership and management transition issues in confidence. In the meantime,  be well! Chris