How Do Dividend Payments to Directors Impact Valuation of Privately-Owned Companies?

Dividends are commonly viewed as an indicator of a strong and successful company, but what happens when these payments affect the company’s overall value? 

For privately owned businesses, this connection can be a difficult balancing act. On the one hand, dividends benefit shareholders and show that the company is doing well. On the other hand, they can decrease the amount of money the company has on hand to invest in future growth, which might affect how potential investors or buyers view the business. 

Our commercial litigation team act in disputes nationally- such as disputes between business owners, investors, shareholders, boardroom disputes between directors, or partners in LLP’s. Valuation can be a critically important aspect relevant not least as your outcome will be highly geared around valuation criteria, and fault.

In this guide, we’ll explore how dividend payments affect the valuation of privately owned companies, breaking down the key factors, methods, and considerations to help you understand the bigger picture. This is only one of the tools and factors we might consider with you depending on your 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 often means rewarding directors who are also 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 that the company has enough profits to cover the payment 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 process is straightforward for smaller private companies, where directors are often 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 £1,000 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 document payments properly with vouchers, resolutions, and records. 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 approach highlights a different part of the business, such as current earnings, future earning capabilities, or how similar companies are viewed in the market. The best method to use depends on why you’re valuing the company, whether to sell it, attract investment, or plan for growth and the industry in which the company operates. 

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 can include “tangible” items like real estate, equipment, and inventory, as well as “intangible” assets like intellectual property or brand value. Liabilities such as debts, loans, or outstanding obligations are then subtracted from this total.

This method is particularly useful for asset-heavy businesses, such as manufacturing firms or property companies, where the value of physical assets is a key indicator of 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) ratio is a common valuation method calculated by multiplying the company’s earnings by an industry-standard ratio. For example, a company earning £1 million annually with a P/E ratio of 10 would have a value of £10 million.

This method works best for companies with 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 such as revenue, earnings, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) to determine its value. 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. By examining their valuation metrics, you can estimate your company’s market value.
• Market Multiples Method: This uses industry-specific multiples, such as price-to-earnings (P/E) or price-to-revenue ratios. For example, if companies in your sector are typically valued at 2x their revenue and your business earns £5 million annually, a market-based valuation would suggest a value of £10 million.

This method is particularly effective for determining a fair market price when selling a business or attracting investors. However, it relies heavily on having sufficient and reliable data on 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. It involves estimating the cash flows a business will likely produce over the next few years and then determining what those future cash flows are worth today using a discount rate. This discount rate usually reflects the company’s cost of capital or the risks involved in the business, with higher risks resulting in a higher discount rate.

This approach is especially beneficial for businesses with strong growth potential, like startups, as it emphasises future performance instead of 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 drop significantly, the company might seem less strong to potential investors or buyers. 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. For valuation methods that rely on cash flow, such as the Discounted Cash Flow (DCF) method, large or frequent dividend payments can restrict expected future cash flows. 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 often suggest that the company is stable and making a profit, which can enhance 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. Some investors view high dividends as a sign of a well-established and thriving business, while others might think that paying out too much means the company isn’t focused on 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 often look at dividend yields in addition to other financial measures when deciding if a company 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 prepare accurate financial records to show that these profits are real. 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. If you are facing allegations of unfair prejudice or consider you are being unfairly treated, or you have some other dispute, understanding your position including regarding valuation can be critically important. Often it can be possible to use factors such as unlawful conduct and allegations of wrongdoing to create leverage and to pressure the other side. By considering the most effective way to engage in valuation on favourable terms you can also significantly influence the outcome for you. 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.

If you are a shareholder or investor involved in a dispute and require assistance in valuation of your claim and your exit, our commercial litigation team at Helix Law would love to speak with you. Our team is experienced and acts in this type of litigation across the country.