A few thoughts on dividends in the family business
“That’s not fair!” is a statement that, when uttered by one’s child, strikes an emotional tone in every parent. In business-owning families, it takes on an even bigger meaning, given that there are many sources of “fair”, and the consequences of perceived unfairness are potentially much larger. Perceived unfairness may lead to consequences affecting not only those directly involved, but a variety of constituencies linked to, and dependent on the family enterprise.
The general concept of fairness in the family business warrants a separate blog, and we promise to get to it in the near future. For now, let us just say that when expectations are clear, and people receive what they expect, they feel some level of fairness (this is true of consequences as well). In this blog post, we look at dividend policies as one source of fairness; a critical source of fairness as it represents something an owner receives beyond growth in unrealizable value and beyond the many non-financial (emotional) benefits available to family business owners.
While there are better and worse ways to set dividends (and hence, better and worse dividend policies), one thing is clear: Dividend policies that build family unity, and that are harmonized with business needs are lacking. Too often, we see dividend policies that only poorly reflect the family’s values and objectives, and that acknowledge the constraints and needs of the business.
A recent Family Business Magazine dividend survey, based on responses from 300 enterprising families in the US showed that “a significant group [80%] of family businesses are paying dividends, but they’re not sure why.” Those with stated reasons for dividends say they are based on anything from a simple target payout ratio of earnings, to prioritizing business investments needs, to a target dividend yield to satisfy shareholders’ ROE expectations.
In our experience, a family’s approach to dividends is often driven by:
The business must be profitable, and family shareholders deserve a reasonable (think, market-based) return on their investment.
Prioritizing the prosperity and well-being of the business, and therefore reinvest as much as is needed and sensible while keeping a ‘sleep at night’ cushion.
Balancing investment needs and shareholder expectations for the long-term health of the family enterprise system.
Viewing the family as a steward to the business, not an owner, thus there should be no financial benefit to stewarding the family company (i.e., this orientation is rare, e.g., Victorinox, the producer of the Swiss army knife).
Seeing dividends as a necessary evil to keep family members quiet so setting dividends at a level that just satisfies that goal.
And sometimes, it is as simple as “we have always done it this way.”
Similarly, as a recent conversation with a family owner highlighted, some may also have their reasons to abstain from making financial distributions to their family shareholders, for example, fear of spoiling the next generation, not wanting to ‘bleed the business dry’, or again, having always done it does way. While well-intentioned, these reasons often yield opposite results. There is no substitute for education, experience, and participation, and the commitment and wisdom these elements bring.
While the underlying rationale shapes a family’s approach to payouts, it does not generally lead to a sustainable solution. So, what makes or breaks a dividend policy?
What do you ‘owe’ your family shareholders?
Disagreements about dividend payouts can lead to serious conflicts among family shareholders. In the absence of sound empirical data, family business leaders are left hanging when it comes to developing a dividend policy that fits their family’s values, needs, and objectives.
Unfortunately, data on dividend policies – written or unwritten – in family enterprises are limited at best. And that may not matter since we have found that using benchmarks for dividend policies can cause more harm than good.
While tempting, we don’t advise policies based on need, on some sort of benchmark, on constant payout, or on company presumed value. And while basing dividends on profit is sound, it must be tightly integrated with many pressing strategic issues.
Consider this: The long-term payout ratio of the S&P 500 is around 50% - and in 2021, payout ranges from zero to 91% of net profit. But that’s the average of all the companies regardless of size, regardless of capital structure (level of debt), and regardless of how fast they are growing.
The time frame really matters because a truism is that over the long run if you pay out too much and underinvest, you will lose the ability to pay out anything. The company owes investors (family) a return, but that does not have to include a dividend stream if the family is aligned around business growth and acceptable risk.
Without clear expectations regarding dividends the family is always at risk. For example, the COVID-19 pandemic caused many families to abruptly cease dividends. In general, business conditions can cause wild swings in dividends paid. The Family Business Magazine survey shows families responded very differently to actual or expected fluctuations in earnings; 20% of families suspend dividends altogether – regardless of any changes in financial performance – and 73% of those whose financial performance had suffered either cutting or suspending dividends.
We have witnessed the fallout following such dividend pronounced changes over the last two years – most often, the fallout resulted from (less involved) family members feeling blindsided by the decisions made by family leadership, from a lack of mitigating measures, or simply from a lack of understanding as to why this measure is warranted. It can take years to rebuild the trust, commitment, and lines of communication shattered by an unexpected and poorly communicated move.
It’s not just the policy that sets expectations, it is basic business understanding, too. Family members often have a limited understanding of the need for investment, and the relationship between continuous investment and long-term business prosperity.
Are you investing enough?
So, what are the things the business needs to invest in? Here are some examples.
Keeping operations up to date: Basic maintenance and making sure nothing will fall apart; expanding capacity so long as market growth continues; staying competitive and not falling too far behind so as to lose share and the ability to generate margin, and staying in government compliance.
Getting ahead on at least one of the competitive dimensions (cost, niche, differentiation): For example, continuing to invest to reduce cost structure (automation, source of supply, productivity, G&A reductions, where stuff is produced, transportation costs, energy costs, etc.).
Developing a managerial and leadership bench and slack resources to protect against times of scarcity (financial, supply, etc.).
Research & Development: Processes and production, new products and services (extensions of existing), new products and services (new platforms, markets, industries), new technologies with no idea of how to get a near-term payout.
Acquisitions to take care of any of the needs above.
These are but a few of the reasons to invest. Educating shareholders about the need to invest and demonstrating how those investments secure their long-term goals is key to shareholder commitment and family unity and can greatly reduce shareholder calls for expanded dividends or even dividends at all.
What is a better way?
We’ve seen and helped many families create sustainable dividend policies. It starts with having a clear idea of how fast you want the company to grow, and the anticipated performance of the business in terms of financial returns. The family should have a long-term target for return on equity (ROE), that is, how effectively is the family’s precious resource, equity, being used.
Next, they need to understand that the ability to grow is completely constrained by ROE; a business cannot grow faster than ROE without taking on more debt, and eventually the suppliers of capital will stop lending you money! Long-term then, we set dividends (as the percentage of profits paid to shareholders) at 1-Target Growth Rate/Target Return on Equity. But to avoid problems from dividend swings, we also recommend using a “smoothing process.”
Unfortunately, in the Family Business Magazine survey, only one out five families smooth out dividends among volatile earnings, and half experience volatile dividend streams. Paying out a percentage of the average of the last three- or five years’ profits usually works best, and is most understandable to all involved. Family members can easily calculate how much dividends will likely go up or down each year and adjust their expectations and spending.
And finally, tell your family that if they want more money, they should look to one another, or outside the business and family. Any other alternative either sets a dangerous precedent or directly threatens business viability. You might as simply switch from long-term dynastic thinking to a “harvest and perish” approach (think eating your seed crop in addition to your feed crop).
If your company cannot grow and return the family’s desired ROE, there are two explanations, and two solutions: Either management and the board are not creative enough to meet the targets, or the ROE target is either not realistic and/or sustainable. If the former is the case, it means pulling cash out to invest elsewhere in the short run, and in the long run, it means making leadership changes. If it is the latter, a conversation around the family’s expectations of the business is warranted. The outcome of said conversation could be a sensible dividend policy that is aligned with the reality and considers of the constraints of the business, while being mindful of the expectations of the family.
