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Take stock of policy

François de Visscher is founder and president of the family business consultancy de Visscher & Co.

A formal dividend policy can help family businesses avoid disputes and to allocate the rewards at regular intervals. But there are pitfalls and a flexible policy that is tailored to the needs of the shareholders is the best bet for success, writes François de Visscher

The lacklustre growth in the public markets during the last few years has put greater emphasis on higher dividend yields for shareholders. In family businesses, pressure to provide dividends has always been an issue, in part due to the lack of liquidity of privately held stocks and the need to provide ongoing income to a diverse yet close family shareholders group. But unlike most public companies, family companies rarely make the effort to create dividend policies.
Lack of liquidity is one of the most common sources of family business shareholder discontent. As the family and the business grow, the disparity in the financial and economic goals of shareholders increases. Some shareholders want the business to grow and the value of the shares to appreciate. They prefer to reinvest excess cash in the business. But shareholders who are not involved in the management of the business tend to see their equity as an investment on which they are entitled to a return comparable with other investments. They often 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 maximise value for all shareholders, the board of directors often faces the challenge of reconciling these divergent liquidity needs and demands. As tangible proof of the value of a shareholder's investment, dividends can provide a safety valve for the pent-up frustration of inactive shareholders eager for a return.

Downside of dividends
Dividends are easy to implement and are easily understood and appreciated by shareholders. However, dividends also have several shortcomings as a liquidity device, and should be considered with other ongoing liquidity options, such as a stock redemption plan or company-sponsored loan program.

First, the regular payment of dividends can lead to unrealistic shareholder expectations. Once shareholders begin depending on dividends to support themselves, any dividend decrease can have serious repercussions for healthy family business and family functioning. Shareholders may bring pressure on the company to maintain a level of 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 growth and capital improvements. This can lead to an ­illiquidity spiral, and hinder the company's ability to pay future dividends. If reinvesting one dollar of cash flow in the business will reap a higher return on investment than the same dollar paid in dividends and reinvested outside the family business, why not give the shareholders the benefit of this differential return?
Third, if dividends are the only liquidity opportunities for shareholders, they are a blunt and uneconomical instrument for rewarding shareholders with multiple and diverse liquidity needs. Every share of the class of dividend-paying stock receives the same return, whether the shareholder needs liquidity or not. For example, members drawing salaries receive the same dividend per share as inactive shareholders who may depend on dividends to meet their income needs.

Assessing liquidity needs and options
Despite the drawbacks, dividends remain an important tool to address some of the liquidity needs of the family shareholders. As the family evolves across generations, the family develops three distinct liquidity needs: the need for current return (dividends or other form of current pay), the need for ongoing liquidity flexibility (the ability to sell shares if and when the need arise) and the need for immediate liquidity (sudden liquidation of shares due to external events). The advantages of running immediate liquidity programmes together with a dividend policy is that those liquidity programmes focus shareholders on the appreciation of the shares and not just the cash return. Hence it relieves the pressure for the company to increase the dividends continuously, irrespective of the cash-flow realities of prudent business management.
The basis for an effective dividend policy is a solid comprehension of the liquidity needs of the various shareholders groups. Family businesses should assess those liquidity needs, through interviews, questionnaires, or group meetings. The goals are to collect information on current income expectations of shareholders; on whether some stockholders anticipate they will need or wish to sell stock in the next four or five years; and on whether those with no immediate need to sell stock nevertheless want the flexibility to sell in the future.

Dividends, usually respond to the current return needs of the shareholders. Other liquidity programmes such as company-sponsored loan programs or annual stock redemptions can meet the on-going liquidity needs of shareholders. The ­company-sponsored loan programme allows shareholders 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. An annual stock redemption programme, on the other hand, allows shareholders to sell their stock periodically at a fixed, formula price to other family members or, if a buyer cannot be found, to the company.

Unforeseen liquidity events, such as estate settlements, divorces or shareholder disputes, often lead to immediate liquidity demands on the company. While those events are difficult to predict, the family business—more than any other publicly traded company—has to maintain the financial flexibility to weather recapitalisation of such type.

Elements of a dividend policy
The creation of other liquidity options, or at least awareness that they exist, can help a company avoid an expensive dividend policy. Decision-making on dividend policy will be more rational and informed once other options have been considered.
Shareholders whose return-on-investment is annually subject to the board members' generosity or whims are unlikely to be happy, especially if they depend on a consistent income stream. Without a dividend policy, the founder and other major shareholders may base the size of the dividend every year on how much they decide they need or want. This is not in the best interests of the business or shareholders.
In framing a dividend policy, the board and shareholders will face a series of questions: Who decides? 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, the family governance body should be involved in formulating the policy. Engaging all shareholders in the discussion also allows the board to educate them.

Dividends are often pegged to earnings or to an objective measure such as the dividend yield of a publicly traded security of a similar type. The yield is the ratio of the amount of the dividend to the value of a share of stock. So the first step in establishing a dividend policy is to define a consistent formula of share value that everyone understands and agrees to.

When the founding generation is still leading the company, the amount of dividends is often based on the financial needs of the founder(s) and the company's ability to pay. As control and leadership moves to the second and third generations, the number of shareholders increases, as does the size of the inactive shareholder group. A formula 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 in a "partnership generation": net cash flow (NCF), which is cash flow after taxes, capital expenditures and 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 10 to 35% 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 to 10% of book value. These parameters help reduce pressure from inactive shareholders for larger dividends, which can adversely affect long-term shareholder value.  

In the fourth and fifth generations there are relatively few active shareholders and a large class of inactive shareholders, and each shareholder's percentage of ownership will be relatively small. Typically, most such shareholders cannot rely solely on dividend income to support themselves. They are more likely than previous generations to see themselves more as "investors" than owners.

This has important implications for the dividend policy. At this stage, other liquidity options deserve 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.

Dividends are usually paid annually. But the real question is under what circumstances dividends should be paid. In the founding generation, dividends may be 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.

Many family firms may want to consider some form of internal recapitalisation that establishes different classes of stock each with a different level of dividend. Such a plan permits, for instance, shareholders who are not active in management to reap a greater percentage of income in exchange for a reduced share of stock appreciation. Under a common arrangement, those 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.

Good dividend policies are flexible enough to respond to changes in the business and the family, but firm enough to manage shareholder expectations.

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