It is unusual to find a business that doesn’t aim to maximise profits. Those profits are usually used in one of five ways:
- to reward employees (including owners) through salaries and bonuses
- to reinvest into the business to generate further profits (including repayment of debt)
- to retain in the business so that the value of the assets in the business increases
- to further non-financial aims (such as charitable ones in the case of non-profits)
- to pay to shareholders as dividends (if the business is held in a company structure)
Different owners have different reasons for ownership
Every owner will have a different objective with respect to how profits are used and ultimately how value will be extracted from the company. One might believe that the best strategy is to reinvest money into the business to grow it fast, so that it can be sold within a short time frame for an increased value, while another might believe that paying cash to investors via salaries and dividends on a long term basis is better.
The optimal strategy will be unique for every business and will change regularly as the goals of the individual owners change.
Control over strategy is, however, not always proportionate to shareholdings.
By default, it is the directors who decide how to use profits and whether to distribute them as dividends. The directors are accountable to the shareholders.
In many small and medium sized companies, the directors are also the shareholders. But not all shareholders might be directors – some may be investors. Those shareholders who are not directors are likely to have far less influence on the board of directors and therefore in votes about how profits are spent (such as on the directors’ salaries) and whether dividends are declared.
Another strategic consideration is exit – sale of the business. Most businesses are bought outright so that the buyer has complete control over future strategy. Sometimes minority stakes might be bought by outsiders, but it is less common, and the price is likely to be lower than for the same proportion if the whole business was being sold. Drag-along clauses are included in shareholders agreements precisely to compel minority shareholders to sell, while tag-along clauses allow minorities to benefit from a seller being found by a majority owner. Business valuations are usually based on free cash flow, so a majority shareholder looking to sell the business is likely to view reinvestment of surplus profits and keeping salaries of directors to a minimum as strategic goals, rather than maximising dividends.
Any group of shareholders is likely to have very different opinions on how profits are used, which is why it is important for every shareholder to agree with the others as to what the policy of the company will be.
How a dividend policy can be set
Policy can be set in two ways. Terms can be placed in a shareholders agreement, relating to the decisions shareholders alone would make (such as whether to sell the company). These would likely complement other policy such as that supporting the exit strategy.
Alternatively, or in addition, clauses can be added to the articles of association to give or restrict the directors’ powers to act (for example, about matters concerning salaries and dividends) without shareholder approval.
For example, it may be agreed that:
- before the directors can declare a dividend, certain conditions must be met
- shareholders share dividends not in proportion to proportional share ownership, but by some other formula that changes over time
- shareholders can or must waive their right to receive dividends in certain circumstances
Tax considerations
There are tax implications when changing a dividend policy.
Dividends are taxed as income, usually at a different rate than capital gains, which would result from sale of the shares. However, there can be reliefs from both types of taxes, which makes minimising tax for all shareholders challenging. Paying one type of tax over another may be attractive for certain shareholders.
A dividend policy can also affect the value of shares. If a buyer of a minority position knows that value can only be returned in more limited circumstances, the price that he or she is willing to pay is likely to be far less.
So the answer to the question of whether you should include a dividend policy or not depends very much on the strategy of the business, and the aims of individual shareholders. It is usually a good idea to consider one, and to revisit it as the business grows.