Establishing a Dividend Policy for a Family-Owned Business

By John Secor, Ajit George, Kyle Gordon and Carson Christus

We are often asked by family business owners looking to develop a divi- Common Dividend Policies dend policy for the best formula to apply.1 Unfortunately, it is not that easy. Fixed Dollar Amount Dividends play an important role in rewarding shareholders but must be viewed in the broader context of the varying needs of shareholders and A fixed dollar dividend is the distribution of a specified dollar amount by the overall capital requirements of the business. For any company, the the company according to a predetermined schedule (such as quarterly right dividend policy marries the needs of its shareholders with what the or annually). This policy provides shareholders with a consistent source business can support based on its operations. There is no one-size-fits-all of liquidity, which tends to build confidence among shareholders. This dividend policy for privately held companies – dividends are one part of a policy is most commonly used by more mature companies with stable capital allocation strategy to maximize shareholder value.2 What is right earnings and steady cash flow, although a company can create a reserve for your family business depends on many factors. that allows it to pay a fixed dividend even when earnings are low or there are losses. Given this predictability, it is favored by a shareholder base Not every company has to issue dividends. Smaller shareholder bases, (for instance, retirees or widows/widowers) that relies on dividends for with true owner-operator dynamics, tend to prioritize business reinvest- yearly expenses. ment over dividends to grow and drive shareholder value. These own- er-operators generally have more flexibility to provide liquidity for them- In theory, fixed payments may be adjusted, but they tend to be “sticky selves and other owners through other means such as salary, incentive upward.” There is high shareholder pressure to maintain dividends at or compensation and other discretionary expenses paid by the company. above the fixed amount, forcing the company in some cases to maintain This approach obviously becomes more challenging as the number of cash reserves or even borrow for an inevitable downturn in the market shareholders increases. and limiting management from allocating these resources elsewhere. As the control and leadership of a family-owned business transitions Additionally, if the dividend is too high, it can siphon a company’s cash to the second and third generations, the desire for liquidity may grow and prevent or delay necessary investments in the business, which could because the number of shareholders increases, as does the size of the impede a company’s ability to thrive in the longer term. When considering inactive shareholder group. This inactive shareholder group, typically a fixed annual dividend, it is management’s responsibility to plan for good minority owners, may view themselves more as investors entitled to a and bad years for the business. tangible nearer-term return rather than owners active in management striving to increase equity value in the long term. This places pressure Fixed Payout Ratio on the business to pay dividends or pursue other liquidity options (for Under a fixed payout ratio policy, the company chooses a metric, such example, a share repurchase program, company-sponsored loan pro- as earnings or free cash flow, and applies the same percentage value gram, recapitalization or sale of the business). Over time, if it is decided to that metric to arrive at the payout amount to shareholders. This policy that dividends should be paid, it becomes more practical to institute a offers the most flexibility to account for the type of business/industry system that provides transparency and predictability to owners. While and shareholder expectations. Using a ratio, as opposed to a fixed dollar dividends can be an effective way to provide liquidity to shareholders, amount, means that the payout is determined by a company’s perfor- it is important to note that dividends are not tax-efficient for both the mance in any given year – when the company is not performing well, company and shareholders. At the corporate level, dividends are paid shareholders will receive a smaller dividend (if any); in a strong year for the from after-tax earnings. At the shareholder level, dividends are taxed as company, shareholders will receive a larger dividend payout. Payout ratio ordinary income rather than at lower capital gains rates. policies do not necessitate maintaining liquid reserves since dividends Outlining a dividend policy without first analyzing the company’s needs are a function of how much cash is available to be distributed. might result in an impractical policy that is unsustainable or not in the best long-term interest of shareholders and the company. Ultimately, the While this policy is flexible and prioritizes business needs, particularly in capital allocation policy should align with the company’s strategic vision. years or periods of underperformance, it can lead to inconsistent divi- Reinvesting in the business and providing liquidity to shareholders are dends and more uncertainty for shareholders. As such, this policy is not not mutually exclusive – both are often necessary for success.3 as suitable for shareholders that prefer more predictable liquidity streams.

For owners that have gone through the capital allocation exercise and Smoothing are committed to formalizing a dividend policy, this article outlines five options. The choice of policy should be informed by shareholder priorities Like the fixed payout ratio method, the smoothing method is based on and specifics for each business. a specific metric (for example, free cash flow), but the payout ratio is typically calculated as a percentage of a trailing multiyear average. For

OWNER TO OWNER 2 “ Effective dividend policies are flexible enough to respond to economic and business cycles yet firm enough to manage shareholder expectations.”

example, a company may choose to set its annual dividend at 10% of are not recurring – there is no requirement to provide liquidity, and the the average of the last three years’ earnings. Using a multiyear average company may choose to simply accumulate cash on its balance sheet. removes the extremes of outlier years, either positive or negative. This For example, some companies may pay a one-off special dividend due method allows for dividend payouts to be more consistent year over year to a major event, such as a recapitalization or business reorganization. while generally trending with business performance. Special dividends may also be distributed following a period of particu- larly strong performance during which cash has accumulated. Special The strength of the policy is also one of its weaknesses – shareholders dividends provide flexibility as to when and why they can be made and may be upset by the lagged response of dividend payouts to business have great potential to enhance liquidity and wealth diversification of growth. The smoothing method is also more difficult to change once shareowners. This type of policy is typically used by shareholders that implemented given its dependence on the company’s performance in are not reliant on dividends as a sole source of income or by companies past years – tenured shareholders who have had to exercise patience may operating in cyclical industries. not be as willing to appease impatient new shareholders. Shareholders of companies with large earnings swings will naturally experience more This policy may lead to shareholder impatience since the distribution is dividend volatility than firms with consistent cash flow. unpredictable, but when it is paid, it may signal that the company has a lack of future investment opportunities. Cash Sweep Conclusion With a cash sweep, or “residual” dividend policy, the distribution is equal to the amount of excess cash (if any) that is left after taking care of the Whether or not an owner realizes it, every company has a dividend business’s capital needs. This approach is a business-friendly policy that policy – even the decision not to pay dividends is a policy! As is the case prioritizes reinvestment over short-term shareholder liquidity and is good with most decisions for privately held (and particularly family-owned) for companies that want to grow the business or pay off debt. It prioritiz- businesses, communication and transparency regarding the dividend es corporate uses of cash and naturally allows distributing excess cash policy – which method is used and why, what the future expectations are, when high returns on investment opportunities for the business are not and so forth – is just as important as the policy itself. Effective dividend available. A cash sweep policy allows the company to sidestep having to policies are flexible enough to respond to economic and business cycles pay dividends in down years, but also avoids the accumulation of funds yet firm enough to manage shareholder expectations. Well-informed during good years. This policy tends to work best for more concentrated shareholders who are aligned on an overarching capital allocation policy shareholder groups who are aligned on prioritizing business needs over for the business will be able to stack hands on a dividend policy that providing liquidity to shareholders. best meets the goals of the owners and enables the business to thrive in the long term. One downside of a cash sweep policy is that dividends may vary greatly 1 depending on annual free cash flow generation and business needs. As Dividends refer to cash returned to shareholders. In the context of a family-owned business and for the purpose of this article, this is further qualified as distributions above and beyond near-term shareholder needs are given the lowest priority, shareholders that required to cover taxes in pass-through entities. might have to wait for an extended period before they receive a dividend 2 For more on the process of allocating capital in a private business, read our second quarter payment. 2016 Owner to Owner article, “Capital Allocation for Private Business Owners.”

3 For more on the delicate balance of managing capital and liquidity demands, read our third Special Dividend quarter 2017 Owner to Owner article, “Balancing Business Reinvestment and Shareholder Liquidity Needs in a Multigenerational Family Business.” A special dividend is a one-off payment to shareholders. It is a more ex- treme version of the cash sweep method except that special dividends

Sample Dividend Policy Approaches

Abrasives Energy Services Telecom Infrastructure Rubber Products Company Manufacturer Business Services Provider Manufacturer

Dividend Policy Fixed Payout Ratio Smoothing Cash Sweep Special Dividend Approach

Payout • 5.0% of net income • 2.0% of rolling average • Free cash flow available • CEO and CFO prepare less S-corporation tax of prior three years’ less anticipated capital an annual analysis distributions market value expenditure less hold- of current and future back of minimum cash capital needs as well • Paid annually • Market value de- on balance sheet as forecasted company termined each year performance and make using a predetermined • Paid annually a recommendation to formula based on com- the board of directors parable public company analysis that includes a discount for size and lack of liquidity

• Paid annually

Conditions • Only paid if total debt / • Dividend paid from an • Second generation • Board of directors EBITDA < 3.0x and re- accumulated reserve to recently bought into approval turn on equity > 15.0% ensure payout in a year the business, and the of negative cash flow policy is being re- viewed given the first • Dividend can be generation’s desire for increased or de- liquidity and the second creased by the generation’s desire to board of directors reinvest and grow the business

While there is no one-size-fits-all dividend policy for privately held companies, it is important that the policy used marries the needs of its shareholders with what the business can support based on its operations and cash flow.

OWNER TO OWNER 4 Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2019. All rights reserved. PB-03056-2019-08-22 Expires 10/31/2021