How do dividend payments to directors impact the valuation of privately-owned companies?
Dividends are often viewed as a sign of a successful and strong company. But what happens when they affect the overall value of the company?
This connection can be difficult to balance for privately owned businesses. Dividends are beneficial to shareholders and show the company’s success. They can also reduce the amount of money that the company has to invest in growth and this could affect the way potential investors or buyers perceive the business. Our commercial litigation team acts in disputes across the country, such as disputes between investors, shareholders, directors, or partners of LLPs. Valuation is a critical aspect, not least because your outcome will be heavily geared around fault and valuation criteria. This is just one of many tools and factors that we may consider depending on the overall dispute. If you’re looking for advice and assistance, don’t hesitate to contact a member of our specialist commercial litigation team and we will be happy to help you.
What Are Dividend Payments?
Dividend payments are a way for companies to share profits with shareholders. In privately-owned companies, this usually means rewarding directors who also happen to be shareholders. Unlike salaries, dividends aren’t paid for work done but as a return on owning shares in the company.
Dividends can only be paid from distributable profits, which are the retained earnings left after all expenses, taxes, and debts have been paid or accounted for. Directors must ensure the company has sufficient profits to cover dividends while maintaining financial stability. Paying dividends without sufficient profits is illegal under the Companies Act 2006 and can lead to directors being held personally liable.
Dividends are usually paid per share owned, with the board of directors agreeing on the amount. This is a simple process for smaller private companies where directors are also shareholders. However, disagreements about how profits are allocated (whether through dividends or reinvestment) can sometimes lead to shareholder disputes about valuation, especially in privately owned companies with multiple stakeholders.
Tax-wise, dividends are usually more efficient than salaries. Each shareholder has an annual dividend allowance, and dividend income above this amount (which is PS1,000 for the 2024/2025 tax year) is taxed at lower rates than regular income.
Paying dividends requires careful management, as it can affect company valuation. Directors must properly document payments with vouchers and resolutions. Records are also required. Excessive dividend payments can lower the company’s retained earnings, potentially indicating financial instability to investors.
Company Valuation Basics
Before we discuss the different methods of providing a company valuation, it’s important to understand why they exist. Each method highlights a different aspect of the business. For example, current earnings, future earning potential, or how similar businesses are viewed on the market. The best method depends on the reason for valuing the business, such as to sell, attract investment or plan growth, and the industry that the company operates in.
Now, let’s go over the main valuation methods used for privately owned companies in the UK.
Asset-Based Valuation
The asset-based approach calculates a company’s value by examining its total assets and liabilities. Assets include tangible items such as real estate, inventory, and equipment, as well “intangible assets” like intellectual property and brand value. This method is especially useful for businesses that have a lot of assets, such as manufacturing companies or property firms, where the value is a key indicator to their financial health. However, it’s less relevant for companies reliant on future earnings or intangible factors, such as tech startups or service-based businesses.
Earnings-Based Valuation
Earnings-based valuation focuses on the company’s ability to generate profit. The Price-to Earnings (P/E), a popular valuation method, is calculated by multiplying a company’s earnings with an industry-standard formula. This method is best suited for companies that have stable and predictable earnings. However, it may not capture the full picture for businesses experiencing rapid growth or operating in volatile markets.
Market-Based Valuation
The market-based method compares the company to similar businesses within the same industry. It involves analysing metrics like revenue, earnings or EBITDA (Earnings before Interest, Taxes Depreciation and Amortisation). Two common techniques under this approach include:
Comparable Company Analysis (CCA): This involves comparing your business to similar companies that have recently been sold or valued in the market. You can estimate the market value of your company by examining their valuation metrics.
Market multiples method: This method uses industry-specific ratios, such as P/E or price-to revenue ratios. If, for example, companies in your industry are valued at two times their revenue, and your company earns PS5,000,000 annually, then a market-based evaluation would suggest a PS10,000,000 value. It relies heavily on having enough and reliable data about comparable companies. Finding relevant comparisons can be a challenge for businesses in niche or emerging industries.
Discounted Cash Flow (DCF) Valuation
The DCF method is an income-based valuation that values a company based on its future earning potential. This method involves estimating cash flows that a company will likely produce in the next few years, and then determining the value of those future cash flow using a discounted rate. This approach is particularly beneficial for businesses that have a high growth potential. It focuses on future performance rather than just current numbers. However, the accuracy of a DCF valuation relies on how realistic the assumptions are about future earnings and market conditions.
How Do Dividend Payments Impact Valuation?
- Reduces Retained Earnings
- When a company pays dividends, it uses money from retained earnings, which are profits kept aside for reinvesting in the business or for financial stability. If retained earnings fall significantly, a company may appear weaker to potential investors or purchasers. With lower retained earnings, less money could be available for growth projects, acquisitions, or paying off debts, which might lower the company’s overall value.
Affects Cash Flow
Dividend payments directly reduce a company’s cash reserves. Large or frequent dividend payments may limit future cash flow for valuation methods that depend on cash flow. For example, the Discounted cash Flow (DCF). It may indicate to investors that the company could have difficulty funding its operations or growth without outside financing, which could lower its perceived value.
Signals Financial Health
Dividend payments can provide insights into a company’s financial situation. Regular and steady dividends can indicate that a company is stable and profitable, which can increase its value. On the other hand, if a company pays dividends that are too high or continues to pay them while losing money, it can raise worries about its financial decisions, which may harm investor trust and decrease its value.
Alters Shareholder Perceptions
Dividends can shape what shareholders expect, affecting how they see the company’s worth. High dividends can be a sign that a company is well-established and successful, while other investors may think the company doesn’t care about growth or new ideas. Finding the right balance is a difficult yet important step in keeping the company’s value in line with what the market expects and avoiding shareholder disputes.
Influences Market Comparisons
Dividend payments can influence how companies are valued based on market methods. Investors look at dividend yields along with other financial measures to determine if a firm is appealing. If a company’s approach to dividends is very different from what is typical in its industry, it can distort valuation comparisons and affect its competitive edge.
Frequently Asked Questions
What Are the Rules on Dividend Payments for Private Companies?
In England and Wales, private companies can only pay dividends if their retained earnings cover them after settling all of the company’s debts. Directors must keep accurate financial records in order to prove that these profits are genuine. Paying dividends when there aren’t enough profits can make directors personally responsible, so keeping good records and getting proper advice is essential.
How Do You Value a Company Based on Dividends?
The Dividend Discount Model (DDM) is the most common method, which estimates how much future dividend payments are worth today by considering the company’s risk and anticipated growth. However, DDM doesn’t take into account growth opportunities or profits that are reinvested in the company, so it’s best used alongside other valuation methods.
Final Thoughts
Dividend payments can be one of a number of elements we take into account, in combination with Director loan accounts and other aspects, in the context of shareholder litigation especially. Understanding your position, including valuation, can be crucial if you are facing allegations that you are being unfairly prejudiced or are being treated unfairly. It is possible to use factors like unlawful conduct or allegations of wrongdoing as leverage to pressure the opposing side. You can also influence the outcome by determining the best way to engage in valuation at favourable terms. For directors and shareholders, understanding how dividends impact valuation is a key part of strategic planning that’s essential to better position yourself in any dispute or litigation.
