Dividends are the route by which shareholders get value back from their investment in a company, and in the agency space MAP represent, this is often the majority of the earnings for the owners, and so it is important.
One of the challenges that this represents however is that it can be all too easy to take this “earning” for granted without always knowing the rules around the issuing and payment of dividends. As a director of the business, you need to know the rules even if only to ensure you stay the right side of them.
To make sure that any dividend payment you make to yourself, or you receive, is a legal dividend, there are three key conditions that must be met:
1. Sufficient distributable profits
Before a company can pay dividends, it needs to have enough profits available for distribution. These can include retained earnings and realised profits from the current or previous financial years, minus any accumulated losses and outstanding liabilities.
It is often a misconception that you can only pay a divided in a profitable year. Even in a loss-making year, as many experienced through Covid, if the historical profits are there, then you can take from that cupboard.
2. Staying solvent
Where any period of trading at a loss then makes this more complicated, is when any risk of insolvency exists.
Companies, and their directors, have a responsibility to make sure they can meet all financial obligations, even after paying dividends. This means that whilst this may have been a normal practice for many years, you do have to consider the overall financial health and future obligations before making dividend payments.
3. Board approval
An area that many small companies just ignore is that the company’s board of directors is responsible for the approval to any dividend payments.
It is the boards responsibility to review the financial information, ensuring that the company can afford to distribute profits without putting its operations at risk.
One practice that can help with this is the formal issuing of Dividend Vouchers.
So how do you know if you are at risk of paying, or receiving, an illegal dividend?
The two most common areas of risk that you would expect to see in a small business are:
1. Insufficient profits
If a company pays out dividends when it doesn’t have enough distributable profits, or goes beyond what’s available and appropriate, then this is considered an illegal dividend. This is based on the fact that such a payment can put the company’s financial stability at risk, therefore harming the interests of creditors.
Many small companies pay dividends based solely on the last year of trading, sometimes because “that is always how we have done it” and don’t always consider the year ahead. Emptying the cupboard without knowing that you can meet future financial obligations can create issues.
If a dividend payment could jeopardise the company’s solvency, hurting the rights of creditors and other stakeholders, then these payments can be judged as illegal.
Such actions have consequences.
As a director you may be held personally responsible and face legal action from creditors, regulatory authorities and often overlooked, other shareholders.
Courts can order the repayment of illegal dividends and impose penalties and fines on the company and its directors.
Under the law company directors have a fiduciary duty to act in the best interests of the company and its stakeholders.
Accordingly, all directors should play a proactive role in ensuring dividends are distributed correctly.
Make sure you keep accurate financial records and can demonstrate that you have regularly assessed the company’s financial position, including seeking professional advice when in doubt.
How MAP can help
MAP offers clients the opportunity to stay on top of their dividend compliance by producing dividend vouchers when dividends are voted by the board. This is a key aspect of good corporate governance and ensures that a company can withstand this area of scrutiny in a due diligence process should you ever come to sell the company.