Entrepreneural Issues

Chapter 14
Dividend Policy

Small firms typically differ significantly from larger, more mature firms in terms of the dividend policies they follow. For example, one study of the financial differences between small and large firms found that the average dividend payout ratio for large firms was in excess of 40 percent, whereas the average dividend payout ratio for small firms was less than 3 percent.10 The study found that the majority of small firms that were planning an initial public stock offering paid no dividends at all in the year prior to their offering.

What are the reasons for this dramatic difference in dividend policies between large and small firms? First, it is likely that many small firms are in the rapid growth phase of their business development. During this early phase, the firm is often short of funds needed to finance planned investments and increases in working capital. Another aspect related to the growth phase argument is that small firms typically have restricted access to capital markets, relative to larger firms. A small, closely held firm has no easy way to raise equity capital other than the retention of earnings. If new shares can be sold, the owners risk a loss of control. In addition, stock offerings for small firms are extremely expensive, both in terms of transactions costs and minority interest discounts (as well as marketability) that investors demand.

Another reason dividend policies differ between small and large firms is because many small firms are closely held by only one or a few owners, and the dividend policy of these firms frequently reflects the income preferences of these individuals. If funds are retained in the firm, taxes are postponed until a distribution is made at some time in the future or until the firm is sold.

As firms mature, their need for funds to support rapid growth declines, and their access to capital markets improves. At this point, they show a tendency to begin or increase dividend payouts. For example, Intel, which was founded in 1968, paid no cash dividends until 1982. Since then, the company has been steadily increasing its annual cash dividend payments. Intel’s dividend payout ratio remains fairly low, reflecting the fact that, despite its large size (sales of $26 billion in 2001), the company still has significant growth opportunities.

Clearly, the dividend policies of small and large firms differ significantly. Small firms often pay out a smaller percentage of their earnings than larger firms because small firms tend to be growing rapidly and have limited access to the capital markets for other sources of funds to support their growth.

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