Dividends

For the last few weeks I have been discussing exit strategies as a means of getting capital to investors so that they can see a return on investment.  While exits are the most likely way for an angel investor or venture capital/private equity fund to see a return on their investment, with longer term investors, including investors in publicly traded funds, a more common way for owners to receive capital from the company is through a dividend.  Dividends have become, unfortunately, less common among publicly traded stocks in the last few decades.  Where, once, an investor would buy shares in a company in order to receive their annual dividend as an income source, nowadays most investors in publicly traded stock only see a return on their investment when they sell it.

First, let’s talk about what a dividend is.  The board of directors of a company can, at its discretion, elect to pay out a dividend to the shareholders of the company.  The dividend can be in cash or in kind.  In kind dividends are usually in the form of stock – frequently stock in the company or a subsidiary.  Usually, the amount of the dividend is determined in aggregate – that is the total amount the company is going to pay out is determined.  That amount is then distributed to shareholders on a pro rata basis (i.e. divided equally among the shareholders according to the number of shares they hold).

The main reason a venture backed company is unlikely to issue a dividend is relatively straightforward.  Any money distributed to investors is capital that cannot be used by the company to grow the business.  A fundamental assumption that is made when Venture Capital firms invest in a company is that the company is likely to grow rapidly, thus growing their money faster than they would be able to do elsewhere.  Consequently, if the company keeps the money and uses it to grow the business, which should result in a greater return on investment than if the company distributes the capital out in order to be invested elsewhere.

From an accounting perspective, dividend distributions appear on the cash flow statement and in the statement of retained earnings, but do not reduce net income.  On the balance sheet, a dividend distribution would affect retained earnings.  Usually, the amount of a dividend distribution will not exceed the net income of the firm in that year. 

While dividends are almost non-existent in venture-backed companies and increasingly uncommon among public companies, privately held companies without institutional investors often use dividends, particularly when all the shareholders are also employees of the company.  One reason for this is that while the salary these shareholders receive as employees is taxed as ordinary income, dividends they receive as owners are taxed at a more favorable rate.

A particular situation to be aware of is the possibility of a dividend preference on preferred stock.  If preferred shares have a dividend preference (usually expressed as a dollar amount per share), then if the company elects to pay a dividend that year, the dividend preference must be paid out first, prior to any common dividends.  Dividend preferences may or may not accrue, depending on the specifics of the preferred stock.  If the preference accrues, then any year in which a dividend is not paid is carried forward.  Should the company elect to pay out a dividend in a future year, all the accrued preferred dividends must be paid out before the common dividend is paid. 

Dividends, therefore, represent an important way to return capital to investors, even though there are a great many circumstances where it is not used.  In addition to all the ways they are functionally important, discussed above, dividends also play an important role in valuation – a topic I intend to discuss in greater depth soon.

Disclaimer: None of the above is intended as legal advice.  If you are seeking legal advice, please consult your attorney.



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