One of the most important actions you can take regarding your company's finances is establishing a dividend policy for the distribution of profits to shareholders, the people who have invested money in your company.
Developing a dividend policy requires balancing the interests of shareholders, who want to maximize their investment returns, with those of the company itself, which must remain solvent while also ensuring its future financial success and growth.
Accordingly, an optimal dividend policy distributes a fair amount of profits to investors while also keeping enough in the coffers to cover current and future costs and maximize the stock price.
If you have a board of directors, the board votes on and determines the dividend policy. If you are running a close corporation, you should include a provision regarding the dividend policy in the company's shareholder agreement.
The following are a few of the more common types of dividend policies to consider.
Regular Dividend Policy
With a regular dividend policy, dividend payments occur at the same rate regardless of yearly earnings. This policy works best when investors prefer the security of a predictable payment, such as is often the case for retired individuals. The shares' stable market value can also help instill confidence in investors and lenders.
For companies with predictable earnings, the best option may be a regular dividend payout policy, which provides shareholders a set dividend at a small percentage of the company's profits. This type of setup also called a low dividend policy, allows the company to reinvest most of its profits.
Companies with a lack of liquidity may choose to incorporate a regular dividend plus stock dividend policy, through which shareholders receive part of the dividends in cash and the rest in additional shares.
Irregular Dividend Policy
With an irregular dividend policy, shareholders are not guaranteed dividends. Instead, a company may decide, based on profits, when and how much to payout.
Companies with irregular or unpredictable income or without liquidity often opt for this type of policy.
One type of such policy is a liberal dividend policy, through which a company distributes a large part of its earnings to shareholders while retaining a minimum amount for the company. Because distribution amounts vary by earnings, dividends are higher in better-earning years, and vice versa.
Residual Dividend Policy
Companies with a residual dividend policy first use profits to pay capital expenditures and then pay dividends out of what's left, i.e., the residual. That means that dividend amounts for shareholders vary depending on the company's earnings and expenditures.
No Dividend Policy
As its name suggests, under this policy, a company doesn't pay dividends to shareholders and instead reinvests all profits back into the company. This type of policy works best for companies poised for sufficient growth and backed by shareholders who prefer equity appreciation over receiving dividends. In essence, shareholders are betting that the appreciation value will eventually exceed the value of dividend payments.
Another reason shareholders may prefer this route is because of the intersection of taxes and dividend policy, namely that capital gains are generally taxed at a lower effective tax rate than dividend payments.