Value can be extracted from a company in two ways: sale of the shares and distribution of dividends.
The strategy that the shareholders agree is important for all owners. That might be to retain all profits, reinvest them, grow the business and sell out completely within 5 years, or it might be to distribute profits as a dividend each year indefinitely.
These two ways need further consideration:
A buyer usually prefers to buy the whole company so that he or she has complete control. Purchases of minority stakes do occur, but are less frequent and are less likely to value the shares highly. Drag along and tag along clauses generally are included in shareholders agreements in order to maximise the likelihood and price of a sale.
By default, dividends are decided each year by the board of directors depending on profits made.
As a result, the owners for whom control of rewards is likely to be a more important issue are those who are not directors (and who therefore cannot influence the board on a vote about declaring a dividend, and who may not receive a salary) and those who are not majority shareholders (and who cannot bring in others to sell the whole of the company).
The issue for the shareholders who do not have a day to day involvement in the company is that cash can be spent by the directors to the benefit of other shareholders (who may be directors). For example, the board of directors may increase salaries by paying bonuses in order to reduce profits available to pay dividends.
Terms in the shareholders agreement, in conjunction with changes to the company’s articles of association can change how decisions on rewarding ownership are made.
For example, owners may agree that:
- any board decision about the declaration of a dividend must be agreed by the shareholders (perhaps on a basis of a vote of hands rather than a vote based on shareholding)
- dividends can only be paid if certain conditions are met
- certain shareholders are entitled to a greater proportional share of dividends than others (perhaps under certain circumstances or for a limited time)
- certain shareholders waive their right to receive dividends (again, for a limited time, on a voluntary basis, or under certain circumstances)
There are tax implications to changing a dividend policy. Capital gains on the sale of the company are taxed at a different rate to dividends, which are taxed as income. The reason for a shareholder wishing to agree on a dividend policy might be to reduce a particular type of tax. Other shareholders should be aware that there are likely to be implications for them as well.
A dividend policy can also affect the value of shares. If a buyer knows that value can only be released in certain ways, he or she may be willing to pay less to acquire the shares.
A dividend policy may very well be a term you want to include in your shareholders agreement, even if your start-up is unlikely to pay dividends for a number of years. A dividend policy affects how investors value the company as an investment and is interlinked to your exit strategy.
You should also certainly look at how directors may propose and declare dividends in the articles of association so that the two documents are aligned.