Creating a Dividend Policy for Closely Held Companies
A well-structured dividend policy is one part of a company’s overall capital allocation strategy. It’s a way to demonstrate confidence in a company’s financial performance while maximizing shareholder returns.
Those gains, however, need to be balanced by ensuring there is sufficient investment in the company’s operations. If the business is underinvested or undercapitalized, the underlying operations will deteriorate, resulting in an inferior return even with a dividend. Ultimately, your dividend policy should weigh the considerations of both your shareholders and the business’ operations.
If you elect to distribute cash to shareholders, you have four main dividend policies to consider.
1. Stable dividend policy. A distribution of a predetermined dollar amount at predetermined intervals (quarterly, annually, etc.). This policy allows shareholders more consistency in planning for personal affairs as they know exactly how much and when they will receive payments from the company. The downside is that shareholders do not see an increase in their dividends in good years, though they are sheltered from a decrease when company earnings are down.
2. Constant dividend policy. A distribution of a predetermined percentage of earnings or free cash flow at predetermined intervals. This policy allows shareholders to receive larger dividends if earnings or free cash flow are up and smaller (or no) dividends if they’re down, which exposes the shareholders to volatility in company performance.
3. Residual dividend policy. A distribution of remaining cash after a company has paid for capital expenditures (capex) and working capital needs. This policy is more business friendly as it allows the company to prioritize growth and business demands. Like the constant dividend policy, this policy is more volatile, creating less certainty for shareholders.
4. Special/one-time dividend policy. A one-time distribution at the discretion of the company. A company may elect to pay out a dividend in response to a major event (such as exceptionally strong quarterly earnings or a windfall from an asset sale) or because it has built up strong cash reserves with no immediate uses for the funds. This policy allows the company to control its balance sheet more closely, but it doesn’t offer shareholders predictable liquidity events.
Other considerations
While most private businesses maintain residual or one-time dividend policies, keep in mind that there is no formal requirement to provide shareholders with routine distributions. Also, these types of discretionary dividends will often be restricted if a company is in default of any lender agreements. They should only be declared and paid after all other obligations and investments are paid.
To make sure your dividend policy is aligned with your business objectives, it should be approved by the board of directors. Your management team and board should weigh the benefits of distributing cash today versus investing the cash in M&A, capex or other tactics that allow for operational growth and, therefore, shareholder value.
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Leah Turnbull and Jack Gauvin
Leah Turnbull, Managing Director and National ESOP Practice Lead, Corporate Advisory Group, BMO | Jack Gauvin, Associate, Corporate Advisory Group, BMO
A well-structured dividend policy is one part of a company’s overall capital allocation strategy. It’s a way to demonstrate confidence in a company’s financial performance while maximizing shareholder returns.
Those gains, however, need to be balanced by ensuring there is sufficient investment in the company’s operations. If the business is underinvested or undercapitalized, the underlying operations will deteriorate, resulting in an inferior return even with a dividend. Ultimately, your dividend policy should weigh the considerations of both your shareholders and the business’ operations.
If you elect to distribute cash to shareholders, you have four main dividend policies to consider.
1. Stable dividend policy. A distribution of a predetermined dollar amount at predetermined intervals (quarterly, annually, etc.). This policy allows shareholders more consistency in planning for personal affairs as they know exactly how much and when they will receive payments from the company. The downside is that shareholders do not see an increase in their dividends in good years, though they are sheltered from a decrease when company earnings are down.
2. Constant dividend policy. A distribution of a predetermined percentage of earnings or free cash flow at predetermined intervals. This policy allows shareholders to receive larger dividends if earnings or free cash flow are up and smaller (or no) dividends if they’re down, which exposes the shareholders to volatility in company performance.
3. Residual dividend policy. A distribution of remaining cash after a company has paid for capital expenditures (capex) and working capital needs. This policy is more business friendly as it allows the company to prioritize growth and business demands. Like the constant dividend policy, this policy is more volatile, creating less certainty for shareholders.
4. Special/one-time dividend policy. A one-time distribution at the discretion of the company. A company may elect to pay out a dividend in response to a major event (such as exceptionally strong quarterly earnings or a windfall from an asset sale) or because it has built up strong cash reserves with no immediate uses for the funds. This policy allows the company to control its balance sheet more closely, but it doesn’t offer shareholders predictable liquidity events.
Other considerations
While most private businesses maintain residual or one-time dividend policies, keep in mind that there is no formal requirement to provide shareholders with routine distributions. Also, these types of discretionary dividends will often be restricted if a company is in default of any lender agreements. They should only be declared and paid after all other obligations and investments are paid.
To make sure your dividend policy is aligned with your business objectives, it should be approved by the board of directors. Your management team and board should weigh the benefits of distributing cash today versus investing the cash in M&A, capex or other tactics that allow for operational growth and, therefore, shareholder value.
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