For the unprepared, it is a question that can paralyze any parent: “Mommy, where do dividends come from?”

Among our family business clients, the issue of shareholder liquidity is always top of mind, and is occasionally a source of confusion among shareholders, managers, and directors.  In this week’s post, we attempt to bring some clarity to the question of where dividends come from.  Large or small, regular or “special” dividends paid to family shareholders can really only come from five places.

1. Earnings from the operations of the family business.

This is the obvious source, but certainly not the only one.  Profitable family businesses face choices when allocating each year’s income.

• Some portion of annual earnings will likely remain tied up in working capital (inventory, receivables, etc.) and not be available for any other use. Accounting income is not cash flow, and working capital can represent a significant drain between net income and cash flow.
• In addition to working capital, the family business may use earnings to purchase long-lived assets (or other companies) to expand the company’s productive capacity in the hopes of generating higher earnings in the future. Since depreciation is a non-cash expense item, it can help fund these expenditures, but any capital investment made in the business in excess of that year’s depreciation charges will come out of earnings.
• If the company has previously borrowed money, the family business may elect to use a portion of earnings to repay that debt. Most loans require at least some degree of annual amortization, so there may not be a lot of discretion here.
• Sometimes families set aside earnings for a “rainy day” fund. Motivations can vary but often include saving for a known future capital expenditure or establishing a cushion against unexpected business interruptions.  How much is “enough” to have in reserve will differ for each family.
• Finally, what’s left over is available to be paid as a dividend to family shareholders. Whether this residual is large or small (or zero) generally depends on where the family business finds itself in the corporate life cycle.  Are there abundant attractive investment opportunities to support growth, or is the business mature, with few growth avenues?

Implications:  Paying dividends out of annual earnings is often considered the most sustainable strategy.  However, it still requires careful balancing of shareholder liquidity desires and the capital investment needs of the business.  Repeatedly “crowding out” corporate investment for the sake of shareholder dividends can undermine the long-term viability of the family business.

2. Divestiture of a significant asset of a segment of the family business.

The family business may not be the optimal owner of every asset that happens to be on its balance sheet.  It may be hard to say goodbye, but sometimes divesting a significant asset or operating division is the right call.  When such a sale occurs, the company will have a reinvestment decision, not unlike that described above, for operating earnings.  The asset that was sold may have secured debt that must be repaid, or the sale proceeds may be redeployed into acquiring a different significant asset.  In any event, a divestiture may provide an opportunity for a family business to pay a “special” dividend to shareholders.

Implications:  Unlike iguanas, family businesses cannot regrow their own tails.  Once an asset is sold, it can no longer provide earnings to the family.  Therefore, funding dividends through asset sales is not a sustainable strategy.  Communicating that fact to family shareholders is paramount when paying these types of dividends.

3. Accumulated cash & investments held inside the family business.

For some family businesses, the dreaded “rainy day” never came.  After a decade (or two, or three) of savings, family businesses can accumulate a significant balance of cash & investments that don’t really support the operations of the family business.  Such large balances naturally invite the attention of shareholders hungry for liquidity.

Implications:  One of our clients refers to large cash balances in family businesses as “lazy capital”.  Cracking open the corporate piggy bank may require management and directors to be more proactive in risk management and more diligent about managing cash flow.  So long as a prudent level of cash is left in the business, distributing lazy capital can be quite productive.  However, as with asset sales, doing so is not a sustainable dividend strategy.

4. The bank.

Some readers are likely to gasp at the thought of borrowing money to pay a dividend.  But money is fungible, so in a very real sense, every family business that pays dividends while having any outstanding debt is effectively borrowing to pay the dividend.  For underleveraged companies, going to the bank for a one-time dividend payment can both help alleviate shareholder liquidity concerns and optimize the family business’s capital structure.  For other companies, living with a prudent level of “permanent” debt can help ease the inherent competition between capital investment in the business and dividends to shareholders.

Implications: Needless to say, borrowing to pay dividends requires a light touch.  However, in family businesses with significant shareholder liquidity and/or diversification needs, a prudent amount of leverage in the business may be the right choice.  Reckless borrowing, in contrast, is not a sustainable strategy.  Lenders like to be paid back, so borrowing money to pay dividends today may constrain dividend capacity tomorrow.

5. New equity investors.

Finally, for some companies, a more permanent solution to shareholder liquidity may be needed.  Growing pools of institutional and family office capital are dedicated to making noncontrolling investments in family businesses.  On the plus side, bringing in new equity investors will provide fresh perspectives on the business and a degree of discipline and accountability that can be lacking when all the ownership is in the family.  However, securing that fresh perspective also means potentially diluting a family culture that has been built over generations.

Implications: “Noncontrolling” is not synonymous with “no influence whatsoever.”  When your family accepts an outside equity investment, there will be strings attached, whether in the form of put (or call) rights for the investment, board representation, return preferences, or what have you.  Every deal is different, and investors compete with one another to present the most “family-friendly” posture to secure the deal.  Your family business will be different — in some way — after accepting outside equity capital.

Regardless of your circumstances, we hope this post can help make having “the talk” with your family shareholders a bit less awkward.  Dividends are an emotionally charged topic for many families, and a framework for discussing dividend payments like that described in this post can help dial down some of the drama.  If you would benefit from an outside perspective, give one of our family business advisory professionals a call to discuss your situation in confidence.