Over many months, my most viewed historical posts are those that address the question of dividends, or distributions, for private companies. I find this interesting, because dividend policy is not a topic that is raised very often in my discussions with private company managers and owners.
Almost no one wants to talk about dividends or dividend policy, but lots of folks seem to have it on their minds. At the outset, let’s be clear what we mean when we talk about dividends or distributions.
- For C corporations. These entities pay taxes directly to the IRS, so we mean dividends paid to owners after all appropriate taxes have been paid to the IRS and other taxing authorities.
- For S corporations and other tax pass-through entities. We assume that profitable pass-through entities will provide tax distributions to owners necessary to pay their pass-through tax liabilities. The distributions we refer to for pass-through entities is what we call “economic distributions,” or distributions in excess of those required for the owners to pay their taxes.
We make these points to avoid any confusion over questions of dividend policy.
Dividend Policy Is One of Three Corporate Finance Questions for Businesses
Business owners are faced with three universal questions as they run their businesses. These questions are addressed by every business every year, one way or the other, directly or indirectly, consciously or unconsciously:
- What is the best capital structure for my company? Every company is financed with a combination of equity and debt. The question for any company right now is this: “Are we using the right combination of equity and debt to maximize returns to our owners?” This is an important question and deserves your attention.
- Of all available reinvestments, which ones warrant selection this year? Every year, every business has an array of investment opportunities, ranging from replacement of existing capital assets to investment in new capital projects to investments in acquisitions to, well, simply holding onto cash. The selection process is aided by knowing the cost of capital, or the required return of the owners of a business. Alternative investments can be arrayed in order of their prospective returns. Those that exceed a company’s cost of capital warrant consideration. Those that don’t meet the cost of capital, if implemented, subtract from the returns available to all owners.
- What are the preferences of the owners of a business for the form of their returns? Shareholder returns come in two forms, capital appreciation, or the growth in value of a business over time, and current returns, as measured by dividends or distributions. Shareholders often have preferences. Unfortunately, the preferences of all shareholders of a business may not always coincide. Nevertheless, this third question regarding dividend policy is the one that generates so much interest and so little conversation.
These three questions are at the heart of what is called corporate finance. That may seem like a fancy term to many business owners, but they are engaged in that process in their businesses every year.
I’ll write more about these questions — and dividend policy — in future posts. For now, let me refer you to an excellent series written by my colleague, Travis Harms. The white paper series is titled Corporate Finance in 30 Minutes: A Guide for Directors and Shareholders.
Take the time to download the paper. Travis has written three more papers, with each of them addressing one of the three corporate finance questions. I’ll point you to them in future posts.
In the meantime, be well!
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