When talking to potential investors, one of the most frequent questions that we get is why don’t we distribute dividends. The reason is very simple: we hate wasting investors’ resources, as frugality is one of our principles. In this article, I will explain to you why dividends are value destructive.
Why Would Someone Want to Cash Out?
People may want to sell mainly for two reasons.
- Partial liquidation. Some people may just want to “celebrate” and spend some of their profits (Mr Frugal doesn’t approve this behaviour). Others may want to sell some shares to “rebalance” their portfolio, after Alpha Rock Capital has increased in value more than their other investments and they consider their exposure to this project is too high.
- Complete liquidation. Maybe they don’t like our project anymore for some reason or they have found something more profitable (if that’s the case, please let us know, we are very interested).
Tax Implications of Distributing Dividends
When Alpha Rock Capital makes a profit, it pays corporate taxes in the US (21% as of now). Then, if it distributes net earnings to its shareholders, every shareholder has to pay taxes again. How much depends on each of the business partners’ situation (mostly what’s their country of tax residence, their level of income and whether they invested as individuals or through some legal entity), but it’s generally between 15% and 30%.
This is something that every investor must pay, no matter if they would have preferred to keep their money invested in the company. If, after receiving that unwanted dividend, they decided to reinvest the remaining money in the company, they would have lost 15% to 30% in the process.
So, just because some people want to get money out, everyone is forced to pay those extra taxes.
So, How Do I Get Money Out of the Company?
Instead of distributing dividends, when an investor wants to liquidate part or the totality of their position, they can simply sell shares. This can be done either to other current investors, for the price they agree on, or to the company itself, which gladly buys shares back at the book value, which is calculated in each monthly report.
If the company has money to distribute dividends, it means it also has money to just buy shares back. For the company, buying back shares at the book value has approximately the same expected return as reinvesting that capital in current businesses or in the acquisition of new ones.
When someone sells shares, it’s only them who pay taxes. And, in many cases, this is even more tax-efficient for those that want to cash out, while those that still want to keep their position are not negatively affected.
I’ll try to explain it with an example.
Distributing Dividends vs Buying Shares Back
There’s a company with 100,000 outstanding shares and 2 shareholders, Investor A and Investor B. Each of them has 50,000 shares.
At the end of the year, the company has made, after taxes, $10,000.
Expected annual returns of reinvesting capital are 25%. Investors pay 20% taxes when receiving dividends. Investor B wants to cash out some money. They are considering what would be the best way to proceed:
1. Distribute Dividends
So, $10,000 are sent to shareholders, $5,000 to each of them. They end up with $4,000 after taxes.
Investor A wants to reinvest their money in the company, as they don’t know anything more profitable.
They value the company at $40,000. So with their $4,000, they buy
\[New\;shares= {{$4,000} \over {($40,000 + $4,000)}} * 100,000 = 9,091\;new\;shares.\]
Now the company has 109,091 shares and $4,000 to invest.
One year later, profits are
\[Profits = $10,000 + $4000 * 0.25 = $11,000.\]
Investor A‘s share is:
\[{{59,091} \over {109,091}} * $11,000 = $5,958.\]
Investor B‘s share is:
\[{{50,000} \over {109,091}} * $11,000 = $5,042.\]
2. Buy Shares Back
Valuing the company at $50,000 (the same as before plus $10,000 profits not being distributed), which is $0.50 per share.
Investor A doesn’t want to sell any, and Investor B wants to cash out his part of the profits (50% of $10,000, so a total $5,000).
Therefore, Investor B sells
\[Sold\;shares= {{50,000} \over {$0.50}} = 10,000\;shares.\]
Now the company has 90,000 shares and $5,000 left.
One year later, profits are
\[Profits = $10,000 + $5000 * 0.25 = $11,250.\]
Investor A‘s share is:
\[{{50,000} \over {90,000}} * $11,250 = $6,250.\]
Investor B‘s share is:
\[{{40,000} \over {90,000}} * $11,250 = $5,000.\]
It’s evident that the second scenario is much more favourable as a whole. Investor A is able to reinvest their part of the profits at 25% instead of 17%, while Investor B makes almost the same in both scenarios.
It’s easy thus to come to our conclusion: there’s no situation in which distributing dividends is better. Sending dividends is essentially a very tax-inefficient, forced partial liquidation for everyone.
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