Dividend policy has been the topic of a number of posts on Mercer Capital’s Family Business Director blog.  Here are a couple of recent examples.

• Dividend Policy in 30 Minutes 
• Five Things to Keep in Mind When Evaluating the Dividend Policy of Your Family Business 

Dividend policy is an important tool for managing the wealth created in closely held and family businesses.

Every Company Has a Dividend Policy

I begin with a not-so-obvious declaration: Every company, whether public or private, has a dividend policy.  In many private companies, the dividend (or distribution) policy may not be articulated or even discussed.  However, rest assured, every company has a dividend policy.

This causes me to ask two questions for business owners and their advisers:

• Is your company’s (or your client’s company’s) policy a good one that is meeting the needs of your shareholders for current income and capital appreciation?
• If you have not articulated your dividend policy, are you working on developing a policy that meets the needs of your shareholders?

“Economic Dividends”

Tax pass-through entities almost always make distributions to owners to pay their pass-through tax liabilities. For C corporations, those taxes are paid directly by the corporations themselves, because, as taxable entities, they are responsible for their corporate taxes.  The dividends we are talking about today are what I call “economic dividends.”  Economic dividends are those received by owners of businesses after federal and state income taxes have been paid, whether by the corporation directly or indirectly, after passing through distributions to owners to pay pass-through taxes.  So let’s see what we mean when we say that every company has a dividend policy.

Net Operating Cash Flow and Economic Dividends

Every company, whether publicly-owned or privately-owned, generates what we will call for today’s post “Net Operating Cash Flow,” or “NOCF.”  If we add back taxes and interest, we will have EBITDA, the subject of several posts on this blog.  There are five uses for a company’s NOCF, as can be seen in the figure below.

The figure above is conceptual in nature and makes no distinction regarding life cycles or maturities of businesses.  From a company’s net operating cash flow, five things can happen that are good for shareholders.

1. Repay principal on debt.  Bankers and other lenders really want their loans made to businesses to be repaid, both in terms of principal and interest, on a timely and/or scheduled basis.  A portion of NOCF may be used to repay principal on debt.
2. Invest in working capital.  Growing companies need working capital to finance inventories and receivables and to be able to pay all expenses on a timely basis.  A portion of NOCF may be invested in working capital to fund a company’s growth.
3. Replace existing capital assets.  All companies make investments, even if minimal for some, in capital assets.  To maintain sales and operations, depreciating plant equipment and computer assets must occasionally be replaced.  So, a portion of NOCF may be used to replace existing capital assets.
4. Invest in new capital assets for growth.  We make a distinction between replacement capital expenditures and growth expenditures to be sure that we always focus on a company’s realistic growth opportunities.  For example, mature businesses with few growth opportunities may focus on replacement capital expenditures and investment in growth capital assets may be minimal.  A portion of NOCF may be invested in new capital assets to take advantage of growth opportunities.
5. Owner dividends/distributions/repurchases.  Any remaining net operating cash flow after the first four uses may be used to make economic distributions to owners.  We include share repurchases in this last use of operating cash flow because they represent, just like economic dividends, current returns to owners.  The difference between dividends and repurchases is that all owners receive their pro rata share of dividends, and only selling owners receive current returns from company repurchases.  Remaining owners benefit from repurchases, but their benefits are generally realized in future periods.

The figure above shows that uses #1 – #4 above contribute to capital appreciation, which is a long-term benefit for owners.  If we add the economic distributions, which are current returns to owners, to capital appreciation for any period, we have the total return to shareholders.

Companies that are experiencing significant growth opportunities may consume all operating cash flow in uses #1 – #4 above.  They will repay debt on schedule, of course, even if they borrow additional funds to finance their growth.  Rapidly growing companies seldom pay economic distributions to owners.  Mature companies with limited growth prospects, on the other hand, likely have no debt and little need to reinvest for future growth.  Mature companies often pay substantial economic dividends.  Companies in between rapid growth and mature stages will likely reinvest subject to the limits of their growth opportunities and pay a portion of earnings in economic distributions.

The figure above does not have a slot for a sixth misuse of NOCF – reinvestment in cash and other low or non-earning assets.  These investments lower the rate of return for all shareholders and should be avoided absent compelling reasons.

Your Company Has a Dividend Policy

Virtually all public companies have stated dividend policies.  They may pay out a certain portion of earnings, say 40%, or target a certain yield on value, say 2%.  Others pay a fixed per share amount for a period, and then periodically adjust the dividend (hopefully up).  Some private companies have similar stated dividend policies.

Often, private companies do not have a stated dividend policy.  When we work with companies, we always ask owners (often the principal managers) about their dividend policies.  I have received replies like this on many occasions: “Dividend policy? We do not have one.  We have never paid a dividend and don’t plan to.” I then suggest that their decision not to pay economic dividends to their shareholders is a policy.

Every company generates net operating cash flow (hopefully positive).  What a business does with that NOCF reflects its dividend policy, or alternatively, its reinvestment policy.  Economic dividends provide a portion of total shareholder returns for each period of operation.  Two questions come to mind:

1. If your company is not paying an economic dividend, does your expected (and historic) capital appreciation warrant the absence of a current return to owners?
2. If your company is paying an economic dividend, are your reinvestment decisions providing a reasonable total return to your owners?

The bottom line is this: Your company (or your client’s company) has a dividend policy.

If you would like to talk about dividend or distribution policy for your company, or any other valuation-related matter, feel free to call me 901-685-2120 or email me mercerc@mercercapital.com to talk in confidence.  Travis Harms is available at the same phone number and his email address is harmst@mercercapital.com.

Until next time, be well!

Chris