Setting Dividend Policy
Dear Advisor: We’d like to establish a dividend policy for our family business. Is there a formula we can use?
Many family businesses would like a “rule of thumb” for setting dividends. Unfortunately, it is not that easy. Family business practices for dividends or distributions range broadly. Many have a policy of simply not paying dividends. Others distribute all available cash. What’s right for your family business depends on many factors.
Getting cash out of the business in a tax-wise fashion is often a question for your accountants and legal advisors. But first, obviously, cash must be available for distribution. To set a dividend policy, most family businesses would want the conservative assurance of a relatively consistent, level of cash flow.
Once the availability of cash is determined, the question of what to do with that cash arises. Should the money be re-invested in the business? Some family businesses distribute money left after funding the requirements of the business’ strategic plan. Such businesses may be relatively sophisticated with such financial tools as capital budgeting and debt-equity ratios.
Other families take the opposite approach, beginning with owners’ expectations about levels of cash returns. A family business we know, owned equally by six siblings, simply seeks to pay out $75,000 annually to each owner. Others state their expectation as a percentage of market value (producing a yield comparable to publicly-traded stocks) or a percentage of book value. In such cases, management is expected to produce financial performance that will allow owners’ expectations to be met. Some family businesses we know have annual valuations conducted and set their dividends at 1-to-5% of that value.
We also think it is important to remember who sets dividend policy. Declaring dividends (and thus determining a methodology for doing so) is the responsibility of your board of directors. Their job, consistent with their understanding of owners’ goals, is to do what’s best for the business and its owners. Setting payout policy and making sure that all parties understand it, is a crucial part of the board’s job.
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