Dividend Policy in Public and Private Companies

Dividend is usually discussed in the context of public companies. Like share buybacks, it is a way of pushing cash back to shareholders.

Companies like Amazon have gone on to accumulate tens of billions of dollars in cash without paying a single dividend or doing a single share buyback, creating considerable controversy. (As of December 31, 2018, Amazon reported USD 31.75 billion as cash and equivalents, but no dividend history.) A pool of cash or highly liquid assets within a company typically reduces return on equity to shareholders.

In the context of privately held companies, and particularly small- and medium-sized enterprises, there are usually fewer shareholders, and there is nowhere near the same level of public scrutiny. Hence, there is considerably less written on the subject. Nevertheless, it is an important issue, which this article proposes to also address.

Dividend policy is the policy a company uses to structure its dividend payout to ordinary shareholders, according to the definition by Investopedia.com. In most jurisdictions, dividends may only be paid from accumulated earnings. Hence if there are no accumulated earnings, it would actually be illegal for a board to declare dividends, and in the case of a subsequent bankruptcy, the board could be held liable for defrauding employees, creditors, suppliers, etc.

Once this hurdle is crossed, there are three types of dividend policies described in the literature. These definitions are, again, from Investopedia.com:

Stable: a dividend that is stable in absolute terms, irrespective of the earnings of the company (subject to the limitation or retained earnings). Whereas earnings are up and down, dividend growth is planned to correspond to the long-term earnings growth of the company. Most investors, generally, appreciate a stable dividend policy, thanks to its predictability.

Constant: a dividend that is constant as a percentage of earnings (e.g. 50% of earnings). Hence dividends under a constant dividend policy are up and down period by period, as earnings fluctuate, compared to a stable dividend policy.

Residual: the company pays out whatever cash it doesn’t need after paying debt obligations, capital expenditures and funding working capital. This makes sense from the company perspective, as raising debt to pay dividends may not be in a company’s best interest.   

In the context of SMEs, it would be more difficult to justify the “stable” policy, as they are more fragile than public corporations, earnings are typically more volatile, as argued in the Financial System Inquiry Final Report into Australia’s financial system in December 2014.

One might say that neither of the three approaches necessarily takes into account the need to generate liquidity to help the company weather a recession or depression.

One might argue that high-tech, biotech or internet companies, or companies operating in volatile sectors where ample cash reserves are needed for rainy days, should be more conservative in their dividend policies, a case made in “Winning Investors Over: Surprising Truths about Honesty, Earnings Guidance, and Other Ways to Boost Your Stock Price” by Baruch Lev.  

A dividend policy often helps to create financial discipline, as company management must manage resources carefully to both look after the needs of the company, as well as to provide a “harvest” to shareholders. Missing a dividend may well raise questions, leading to possible accusations of mismanagement, whether justified or not.

Even if a company does not have an explicit dividend policy, its history of declared dividends provides an implicit dividend policy to investors.

Whereas private individuals who own publicly listed shares typically own a diversified portfolio of shares, owners of private companies often have “all their eggs in one basket”. Hence for these shareholders, a dividend policy may be the starting point for a private individual shareholder to begin a process of investing dividends into a more diversified portfolio.

Questions of Control

Many owners of private businesses hesitate to do so because they feel reassured by the fact that they can better control a company under their surveillance; they have zero control over a large publicly listed company. But in most instances this is a false sense of security, as a large public company generally has a much lower level of risk than a smaller privately owned company.

A private company is typically a “high risk high return” type of investment, from an individual shareholder point of view, probably warranting diversification into lower risk equities and assets.

Where a company does not have a pool of cash or liquid assets, or where the goal is to achieve a diversified portfolio more quickly, this objective might be accomplished by an owner selling a minority interest in the company, to immediately redeploy a substantial amount of cash into a diversified portfolio.

Of course, where a company is in high growth phase, or has enormously high-return investment opportunities, paying out zero dividend may be fully justified.

Where there are no investment opportunities and the company is a “cash cow”, it may make sense to have an extremely high dividend payout ratio.

In conclusion, whether for private or public companies, devising a dividend policy requires good judgment in balancing various factors, and creating consensus among shareholders.

Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.