What exactly is a dividend?
We often hear about dividends, shares and yields when talking about evaluating companies. One of the big misunderstandings is what dividends are, how they work and how they can benefit you as investor or shareholder.
In short, a dividend is a reward paid to the shareholders of a company for their investment in a company’s equity, and it usually originates from the company’s net profits.
We think we know what a dividend is, but as a businessperson it pays to know exactly how and when companies pay dividends, as well as the different types of dividends out there. As the owner and director, you should also be thinking about receiving dividends from your company. Which is better – dividends or a director’s salary? Both have different tax implications. Let’s dive in.
Dividends are regular profit-sharing payments made between a company and its investors, and the price is determined by the board of directors. Dividends are paid according to how much stock an investor or shareholder owns, usually as a proportion to the percentage of equity owned, and can be paid monthly, quarterly, semi-annually or annually.
Companies pay dividends for many different reasons, including to attract and retain investors.
Dividends are attractive incentives for shareholders, so that they know that the company they are investing in is profitable and that there is a good possibility of future earnings. Not all companies, however, pay dividends, some choose to reinvest profits back into the business.
For a company to share profits with investors, it must actually have profits to share. As a result, dividends are most common from well-established companies that generate consistent revenue, as opposed to startups. Stocks of such companies are usually known as income stocks and pay regular dividends.
Different Types of Dividends:
Let’s look at the different ways in which your investment can reward you.
- Cash Dividend
Cash dividends are the most commonly used dividend type. In this type of dividend, the dividend amount is paid by transferring a sum of money from the company directly into your bank account. Pretty straightforward.
- Stock Dividend
Stock dividends refer to the dividend which is paid by allocating a specific number of shares to the existing shareholders without the company taking any kind of consideration. These shares may then generate money in the future, or can be sold in order to generate cash.
- Property Dividend
A property dividend is paid using non-monetary items such as assets or stock inventories rather than directly paying cash. The company pays this dividend when it does not have enough cash reserves to pay off dividends. Needless to say this is not a good sign. This is also referred to as a dividend in-specie.
- Liquidating Dividend
When the board of directors plans to return the funds originally contributed by shareholders as a dividend, it is called a liquidating dividend and may be a precursor to shutting down the business.
Why Companies Don’t Pay Dividends
There are a number of reasons why companies might choose NOT to pay dividends. When companies pass their profits on to the shareholders, they aren’t reinvesting them into the company and betting on future growth. Dividends are also less common with startups and other growing companies, as they are forced to reinvest any extra capital into building their assets and ensuring the company’s future. This is not always bad news. These stocks, known as growth stocks, are often considered a good trade-off for investors because they expect significant capital gains once the company has scaled.
Salary or dividends: which is better for business owners?
As a director, should you pay yourself a salary or get dividends? You have a lot of love for your business, but you also know that love doesn’t pay your bills. Many people are under the impression that owning a business makes life easier, but it often just means that you are responsible for everyone’s salaries – not just your own. As the business owner, however, you still need to pay yourself to cover your personal expenses and justify the time you spend working in your business.
Tax experts say small business owners have three options; a salary, dividends paid from after-tax profits and borrowing from the company. The decision on how to reward yourself can be quite tricky, mainly because of the tax implications if the wrong choice is made. This could affect not only your personal income, but the profitability of the business and everyone who depends on it for a salary.
If you find Income Tax and its implications intimidating, then call in the experts to advise you. At OCFO we specialise in advising startup directors on the complexities of salaries, tax and coping with scaling a new company. Our CFOs love helping founders put processes in place to make sure that profit is planned, set aside and paid out frequently in a predictable manner, and that you get rewarded through a salary or robust dividends.
Few things are as inspiring to a founder team as a consistent, growing stream of dividends that serve as the reward for the risks they have taken and the blood, sweat and tears they have poured in over the years. Along with this, we make sure that founder salaries are market related and secured, and that the tax man is always planned for.
If you want to learn more about profit maximisation and how to handle dividend payouts, then reach out to the team at OCFO, your on-call financial partners.