Can Small Businesses Teach Blue Chip Corporations Something About Paying Profits?

Can Small Businesses Teach Blue Chip Corporations Something About Paying Profits?

progressive-flo

While I had a bunch of different titles for this post including “Would You Invest in a Variable Dividend Paying Stock?” and “Is there a Better Way to Pay Dividends?” I went with this one because I can’t believe that this lesson small private businesses can teach larger blue chip corporations which pay regular dividends hasn’t been picked up yet.

The reason I invest in the dividend aristocrat stocks is for the predictability of increasing income, however, I think there is a company that might have the right idea how to pay out profits and it is similar to how most small private corporations  and Limited Liability Companies run their businesses.

How do Most Small Private Businesses Pay Out Profits?

Most small businesses owners take a salary and then distribute profits, if there are any.  If I had to guess the primary reason this is the structure for most incorporated private companies is because of how the government taxes business owners.  Without getting too technical, as it isn’t the point of the post,  business owners who own a pass through entity (S-Corp/most LLCs) have to pay Self Employment tax.  According to the IRS Self Employment tax is,

a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners.

Put a simplier way, the government is grabbing their FICA tax normal wage earners and their employers put into the tax system.  What isn’t subject to Self Employment Taxes? Profits distributed from the company.  Before you go and get greedy and say you’ll take 100% as profit and nothing as a wage….the IRS has already prosecuted a lot of greedy people.

Let’s ignore the tax issue just for a second and discuss why this type of set up makes sense logically speaking.  The business owner is only invading the business checking and savings accounts if he or she thinks that the business can handle the expenditure.

Although it may seem like the board of a public corporation goes through the same process it is much more complicated considering one member might feel that it is the right move to pay a dividend vs 3 that don’t.  Then there is a company that leaves the decision up to math.

Example of a Variable Dividend Paying Stock

All my research on the topic leads back to one example of a United States variable dividend paying stock.  It should be noted that this company differs to most non-regular dividend paying stocks insofar as it provides investors the formula it uses to determine if it will declare a dividend.  This means you are not at the whim of the board.  The company I am talking about is Progressive (PGR) with their annoying spokeswoman and their clear dividend policy,

Our dividend is paid annually in a lump sum, in an amount that is calculated on the basis of our insurance operating performance for the year. Our annual dividend policy is intended, along with other tools that we use, to regulate our accumulation of capital beyond what we need to support our business objective of profitable growth and to return capital to shareholders when it is most appropriate to do so. In addition, because we use a factor to determine the annual dividend amount that we also use to determine cash bonuses for our employees, the policy further aligns the interests of our employees with those of our shareholders.

Progressive Auto Insurance - Annual Variable Dividend Policy

Basically, the company will determine the dividend based on profitability and not other factors, much like a small business does.   While I think it is a fantastic way to run a business, regardless of size, I like the predictability that I have built my perpetual income machine around.  As such, I am not likely to buy PGR anytime soon.

Are you familiar with any other US companies that follow this type of set dividend formula?  Do you own PGR? Did you know about this variable dividend arrangement?

6 Responses to Can Small Businesses Teach Blue Chip Corporations Something About Paying Profits?

  1. Interesting post. I wonder if the target percentage stays the same, or whether Progressive changes it whenever they want.

    Nokia has a similar dividend policy, paying out a percentage of profits as their dividend.

    • I am not sure about the target percentage question…I’ll look into it.

      Does Nokia apply that dividend policy to its ADR as well or just it’s original stock?

  2. These days, most big companies don’t like paying dividends. If they use those same funds to buy back stock which artificially inflates share prices, the value of their stock options increase much more. When the executives grant themselves stock options, they don’t get paid for dividends.

    It’s not about the shareholders; it’s about the execs (often times). Examples about with old economy companies, but study after study show companies often buy back shares at the wrong time and really just enrich the options holders.

    • I never really understood the buyback. It is fantastic on paper, but never seems to get implemented correctly.

      The buyback should happen at the exact time that insiders are buying (legally). That way there is some skin in the game – I feel like (read: no real research) that buy backs occur at opposite times of legal insider buying.

  3. I was not familiar with variable paying dividends, I just know most companies pay every quarter and that’s about it.

    It is an interesting concept though.

  4. Interesting post. I worked at a large private company and they had a profit sharing program. It was a nice Christmas gift for employees and kept us motivated. It worked well for the most part.

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