by François M. de Visscher
For many family firms, the lack of a dividend policy is a serious omission at best, and a recipe for a shareholder-relations disaster-or a family feud-at worst. At the same time, a dividend policy formulated without consideration of other liquidity options, and outside the context of the company’s overall capital needs, is also a serious mistake. There are many ways to slake the thirst of shareholders, particularly inactive shareholders, for liquidity. Dividends are but one.
Lack of liquidity is one of the most common sources of discontent voiced by the shareholders of family firms. As the family and the business grow, the disparity in the financial and economic goals of shareholders increases. The shareholders active in management want the business to grow and the stock to appreciate. They prefer to see “excess” cash reinvested in the business, rather than frittered away on dividends. But the inactive shareholders tend to see their equity as an investment on which they are entitled to a return comparable with other investments. Oftentimes they view the business more as a cash cow than a long-term family enterprise, especially if they do not have other sources of income.
In its duty to maximize value for all shareholders, the board of directors is often faced with the challenge of reconciling these divergent liquidity needs and demands. Unfortunately, dividends are often the only device available for providing some liquidity to shareholders. This is because dividends provide tangible proof of the value of a shareholder’s investment, and thus can provide a safety valve for the pent-up frustration of inactive shareholders eager for a return that can be banked. The board and family leaders often see such payments as a kind of “peace money” to keep inactive shareholders happy.
Dividends do play an important role in rewarding shareholders and providing a current return on their often illiquid family investment. The payments are easy to implement and are easily understood and appreciated by shareholders-provided the firm has a clearly articulated dividend policy. However, dividends also have several shortcomings as a liquidity device, and other options, such as a stock redemption plan or company-sponsored loan program, should be considered. As family business owners and board members consider this view on dividend policy, they will begin to see the liquidity forest, and not just the dividend tree. Liquidity options, moreover, should be developed as part of a broader Family Business Project, which starts with a mission statement and a strategic plan.
The downside of dividends
Before explaining what I mean by a Family Business Project, let me summarize the pitfalls of dividends for family firms.
First, the regular payment of dividends can lead to unrealistic shareholder expectations. Once shareholders begin to depend on a stream of dividend income to support themselves, any decrease in dividends can have serious repercussions for the family business and for healthy family functioning. Shareholders will be quick to express their discontent. They may bring pressure on the company to maintain a level of dividend payments long after such dividends can be justified by the company’s financial performance.
Second, increasing demands for dividends can strain cash flow and prevent the company from reinvesting profits in future growth, as well as in badly needed capital improvements. This can lead to an illiquidity spiral which hinders the company’s ability to pay dividends in the future. In terms of allocation of financial resources, dividends may not be the most productive way of meeting shareholders’ return-on-equity objectives. If one dollar of cash flow reinvested in the business will reap a higher return on investment than the same dollar paid out as a dividend and reinvested outside the family business, why not give the shareholders the benefit of this differential return?
Third, dividends are a blunt instrument for rewarding shareholders with diverse liquidity needs. Every share of the class of dividend-paying stock receives the same return, whether the shareholder needs or desires liquidity or not. For example, members who are drawing salaries will receive the same dividend per share as the inactive shareholders who may depend on dividends to meet their income needs. While this non-discriminatory policy honors the principle of equal rewards for equal ownership, it makes dividends a less precise liquidity tool than other options.
Finally, dividends are tax-inefficient for both the company and the shareholders. At the corporate level, dividends are paid from retained, or after-tax, earnings. At the shareholder level, dividends are taxed as ordinary income rather than at the lower capital gains tax rates which would be available if stock appreciates in value and is sold.
A Family Business Project
While there are some drawbacks to dividends, they remain an important tool when developed in the context of a Family Business Project. Such a project defines the vision for the business and the short- and long-term expectations of shareholders and management. The project includes: 1) formulating a mission statement and strategic vision and plan for the company; 2) determining the liquidity needs and expectations of the various shareholders; 3) establishing liquidity programs for shareholders; and 4) setting a dividend policy. Leap-frogging to dividend policy without consideration of the other elements of the Family Business Project may result in a policy that is either ill-conceived, unsustainable, or not in the best interests of either the shareholders or the company.
In a Family Business Project, the shareholders participate in discussions of the company’s strategic plan, including the setting of expectations or targets for the rate of return on equity. In addition, they are involved in defining the corporate and family values, and the extent to which the former should reflect the latter. For example, financial objectives must be considered in light of other values such as the family’s commitment to certain philanthropic activities or community and social causes. The Project is discussed and formulated in the family council, at a retreat, or in a series of family meetings. Through their participation, family member-shareholders become invested personally and emotionally, not just financially, in the long-term success of the enterprise.
Many family business owners leave basic yet essential questions, such as the principles and values they wish to see reflected in the company’s activities, to the board of directors. I recommend strongly that both the board and the shareholders work on these issues together. They should meet annually to reconsider and refresh their discussions and the plans and policies they have put in place. The Family Business Project process not only keeps shareholders happy, it makes good business sense. It is essential to maintaining the active, enthusiastic family support that plays such an important role in the success of a family enterprise. The basic components:
Mission statement. A mission statement confirms the business that the family is in, the objectives of the shareholders, and the rules of governance and family involvement. It also addresses the broader social and spiritual goals that the family owners wish to see represented in their business. In sum, the mission statement defines the values to be adhered to in the family and in the business.
Strategic plan. A strategic plan answers such basic questions as: What is the strategic vision for the company? How is long-term value best built? How will company growth be financed? How can we increase the company’s value? What rate of capital appreciation is both desirable and realistic? What is the company’s plan for achieving its goals over the next five years? The plan helps the family understand how the company will continue to create value for the shareholders, consistent with the values described in the mission statement.
Liquidity assessment. In addition to strategic and values-oriented questions, the Family Business Project should periodically assess the liquidity needs of the various shareholder groups. This can be done through interviews, questionnaires, or in group meetings. Whatever the method, the goals are to collect information on the current income expectations of shareholders; on whether some stockholders anticipate they will need to, or wish to, sell stock in the immediate future, say, the next four or five years; and on whether some who have no immediate need to sell stock nevertheless want the flexibility to sell in the future. The information acquired through this assessment process is essential to formulating the appropriate liquidity program, including the dividend policy.
Liquidity programs. Ideally, liquidity programs should respond to all three of the needs listed above. Dividends, of course, can only respond to the first need, though they may affect how shareholders feel about immediate and future desire to sell stock. It should be pointed out, however, that even current income needs can be met without payment of dividends. For example, a company-sponsored loan program is a liquidity option that can meet the immediate capital needs of shareholders and allow them to hold on to their stock without cost to the company. The company arranges for commercial banks to lend shareholders money using their stock as collateral.
One liquidity option I frequently recommend is an annual stock redemption program that allows shareholders to periodically sell their stock at a fixed, formula price to other family members or, if a buyer cannot be found, to the company. The key to a successful stock redemption program is devising an appropriate formula. The annual formula price is typically derived from standard valuation criteria, including income approaches, comparisons with the values of comparable public firms, and data from previous arms-length transactions. The emphasis, however, is on available cash flow and borrowing capacity, since these are the primary sources of funds for stock redemption programs. (There are many other liquidity options that should be considered as well. See “Happiness is Stock Liquidity,” Family Business, Spring 1995.)
Elements of a dividend policy
The creation of other liquidity options, or at least awareness that they exist, can help a company avoid an unnecessarily expensive dividend policy. This is not to say that family firms should avoid paying dividends, or even that dividends are a liquidity option of last resort. The point is that decision-making on dividend policy will be more rational and informed once the other steps have been taken and options considered.
A clearly articulated dividend policy establishes expectations. Shareholders know when and under what circumstances the company will pay dividends, and perhaps even how much. While a dividend policy might represent a compromise of interests, it is superior to an ad hoc policy in which the board revisits the issue each year. Shareholders whose return-on-investment is annually subject to the board members’ generosity-or whims-are unlikely to be happy shareholders, especially if they depend on a consistent income stream. Without a dividend policy, moreover, the business may be subject to another pitfall common to family firms: The size of the dividend may be determined every year by how much the founder and other major shareholders and family members decide they need or want. Such short-term thinking is not in the best interests of the business, or even in the best long-term interests of the shareholders.
In framing a dividend policy, the board and the shareholders will face a series of questions: Who sets company dividend policy? When should dividends be paid? To whom? How frequently? How large should the dividend be? How flexible should the policy be?
Here are some possible answers to those questions:
Who decides? Obviously, the company’s board of directors has the authority to declare dividends. A dividend policy sets the guidelines for the board in deciding questions such as when, how much, and to whom. Ideally, all shareholders, whether active in the business or not, should be involved in formulating the policy. Nothing defuses tensions in a family business better than ensuring that all shareholders feel they have had a fair hearing on matters of importance to them. Engaging all shareholders in the discussion also gives the board an opportunity to educate them that dividends are only the current return portion of the overall return on equity that comes with stock appreciation over the long-term.
A dividend policy, clearly spelled out and communicated to all the shareholders, helps avoid family conflict. It requires a delicate balancing of interests, and the business owner should not underestimate the importance of giving all shareholders an opportunity to be heard on the issues. Depending on the size of the shareholder group, the policy can either be approved at the shareholder level by consensus, or, if the group is large, through the formation of a family council or a shareholders’ assembly that gives approval to proposals developed by the larger group.
Once a dividend policy has been decided on and approved, it is then up to the board of directors to apply the criteria established by it every year (or according to whatever schedule it provides) and to declare dividends based on the specified formulas.
How much? This is perhaps the most difficult issue of all. Dividends are often pegged to earnings (either pre- or post-tax), or to an objective measure such as the dividend yield of a security of similar type. Since the yield is the ratio of the amount of the dividend to the value of a share of stock, the key is to find a formula for determining share value that is understood and agreed to by everyone. I favor a formula based on cash flow and book value, not earnings. But the appropriate dividend depends to a large extent on the generation that is at the helm.
When the founding generation is still leading the company, the number of shareholders is likely to be small; the ratio of inactive to active shareholders, moreover, is low, if indeed there are any inactive shareholders at all. With relatively little outside demand for dividends, the amount of dividends is typically determined in the founding generation by two factors: the financial needs of the shareholders and the company’s ability to pay.
As the control and leadership of the firm moves down to the second and third generations, the number of shareholders increases, as does the size of the inactive shareholder group. It becomes much more important to have a formula in place that will help determine whether dividends should be paid at all and, if so, how much.
Two measures of the company’s financial health need to be taken into account in setting a dividend policy: net cash flow (NCF), which is cash flow after taxes, after capital expenditures, and after debt service; and the balance sheet, which reflects the company’s overall fiscal health.
I often recommend that a percentage of NCF be set aside for dividends-typically between 10 percent and 35 percent-but with one important condition: The total amount paid out should not be disproportionate to the overall book value of the company. For example, many dividend policies state that aggregate annual dividends should not exceed 5 percent to 10 percent of book value. These parameters help reduce pressure for larger dividends from inactive shareholders, which can adversely affect long-term shareholder value. Just because you have dividends, however, does not mean that they should automatically be paid whenever the criteria are met. It means only that dividends will be determined by these guidelines if the board, after considering all the relevant factors, decides to declare a dividend. (Of course, there may be external limitations. If the company has loans from banks or other lending institutions, for example, the loan agreements may well place limitations on the amount of dividends that the board can declare.)
As control of the family firm passes to the fourth and fifth generations, there are likely to be relatively few active shareholders and a large class of inactive shareholders, and each shareholder’s percentage of ownership will be relatively small. Typically, most shareholders cannot rely solely on a stream of dividend income to support themselves. Furthermore, they are more likely than previous generations to see themselves more as “investors” than owners, and they will be scrutinizing the return from their investment much as they do other investments.
This has important implications for establishing dividend policy. Indeed, it is here that other liquidity options must be given the most consideration because the yield on the investment in the family firm (the ratio of the dividend to the value of the stock) is likely to make some inactive shareholders eager to find a way to exit the investment, capture their capital gains, and move on. There is likely to be increased pressure for higher dividends, and it may be more difficult to live within the general parameters that guided earlier generations.
When should dividends be paid? Usually dividends are paid annually. But the real question is under what circumstances dividends should be paid. In the founding generation, as we have seen, dividends are often an important source of income for the relatively few shareholders; they should be paid when there is sufficient cash in the business to both invest in future growth and pay a dividend (if needed to meet living needs). This is a necessarily vague formulation which requires a balancing of interests. But, whether the business is in the founding or any successor generation, the critical question should not be whether shareholders need a dividend, but whether using cash to pay dividends is the best way to maximize shareholder value (the board’s fiduciary duty). As I’ve argued, there may be times when NCF justifies payment of a dividend within the terms of the dividend policy but payment is not the best way to maximize long-term shareholder value. Just because dividends can be paid does not mean they should be paid.
This becomes an especially critical issue in high-growth companies which have opportunities to increase share value dramatically over the long run. Tax considerations also enter into this calculation, because reinvestment is a form of tax deferral. Shareholders pay no income tax on a dollar of profit that is reinvested rather than received as dividends. If that investment results in greater capital appreciation of the stock at a later time, it will be taxed at the lower capital gains rate when the gains are realized.
As noted at the beginning of this article, however, there are other important benefits from paying dividends that cannot be measured precisely in dollars and cents. This is what might be called the “peace dividend.” The company may believe that a more immediate reward to shareholders serves its long-term interests in that it prevents discontent from spreading and keeps everyone in the family pulling in the same direction. The question of when to pay dividends should not be governed by hard and fast rules. Family firms must weigh multiple considerations-some financial, some emotional.
Who is entitled to what? As mentioned earlier, one of the disadvantages of dividends as a liquidity tool is that they reward all shareholders at an equal rate, regardless of their income or needs. It may therefore be appropriate for many family firms to consider a recapitalization that establishes different classes of stock. Such a plan permits inactive shareholders to reap a greater percentage of current income in exchange for a reduced share of future stock appreciation. Under a common arrangement, the passive shareholders receive a dividend-paying preferred stock while those active in the business are given common stock that appreciates in value as the company grows and may or may not pay a dividend. It is beyond the scope of this article to discuss recapitalizations and the various ways of apportioning benefits among different classes of stock. But family firms should be aware of this option and explore it with their advisers.
How firm a policy? Good dividend policies are flexible enough to respond to changes and the ups and downs of economic and business cycles, but firm enough to manage shareholder expectations. Getting locked into dividend payments that are not sustainable, or advisable, can seriously hurt growth. That’s why I define net cash flow as cash on hand after various other obligations are met, including the capital expenditure needs of the business. A company that has a chance to make an outstanding acquisition may decide that, to take advantage of the opportunity, it will have to use cash that would otherwise be paid out in dividends. At other times, negative developments in the economy, such as recession, may make payment of dividends inadvisable. In both cases, the company needs to retain considerable flexibility in its dividend policy.
Making dividend decisions on an ad hoc basis from year to year serves neither the business nor its shareholders, and can open the door to infighting and conflict among different shareholder groups, and between shareholders and the board. There are a variety of methods for determining whether to pay dividends and how much, but each businesses’ circumstances are unique and must be taken into account when setting dividend policy. Ensuring that all shareholders have an opportunity to present their views in the creation of the dividend policy can go a long way toward achieving unity in the family and business.
François M. de Visscher is president of de Visscher & Co., a financial advisory firm in Greenwich, CT. He has had wide experience in fulfilling the capital needs of family companies, starting with his own family’s business, a fourth-generation, multibillion-dollar manufacturer of wire and steel.