Post-IPO Payout Initiation – Dividends & Share Repurchases

The fundamental question for the managers of a firm is how to create a positive financial return for the owners of the company. This financial return is a combination of capital appreciation and cash distributions. These cash distributions can be in the form of dividends, share repurchases, or a combination of both. The initiation strategies for these payouts can increase the returns for investors, raising the company's overall valuation.

Companies that are registering to go public are often looked at differently with regards to payout initiations. Most registering companies know that the most important way to add value for investors is to grow the business and create growth in share value. This means that in many cases, companies may not plan on offering dividends or making a stock repurchase for many years after the IPO.

While many registering companies aren’t planning on a payout in the near future, there are also a significant number of IPO-registering and newly-public companies that do initiate payouts. Some IPO firms offer dividends at the time of the IPO, or even pay dividends beforehand.¹ In addition, a significant portion of companies pay dividends within a few years of going public. One study found that about 22% of companies start paying dividends within 3 years of going public.² Thus, it is in the best interest of any company that is registering to go public to consider the factors that might prompt them to offer a dividend or initiate a stock repurchase in the period following their IPO.

This article describes the basic mechanics of both strategies and examines the differences between them. This article also describes the various factors that researchers have found to be influential in determining how and when to initiate a payout.

Dividend and Share Repurchase Mechanics

Dividends and share repurchases both add value to investors, but in different ways. Understanding the basic mechanics of how each payout method works will lay the foundation for understanding why companies may choose to use them.

Dividends

In the most basic sense, dividends are direct payments of cash from the company to shareholders, with a certain amount of cash paid per share. For example, if a company had 10 million shares outstanding, and had $10 million in cash that it chooses to distribute as dividends, each shareholder would receive $1 per share owned. Normally the funding for these dividend payments comes from the company’s annual or quarterly profit, or retained earnings. However, dividends can also be also financed in other ways.

Share Repurchases

Instead of using cash to pay investors directly, share repurchases should cause the value of each remaining share to grow. When a company initiates a share repurchase, it announces its intentions to shareholders and sets a price at which it will buy back shares from current shareholders. Once these shares are purchased, the remaining shares effectively represent a larger portion of ownership in the company. For example, imagine that there is a company with 10 million shares outstanding, and a market value of $10 million. If the company repurchases 1 million shares, and the underlying value of the company stays the same, then each remaining share should increase in value from $1 to $1.11.  In this way, shareholders see return in terms of increased value per share.

Dividends vs Share Repurchases

As demonstrated above, both payout methods increase shareholder value; however, the other consequences of each payout method differ significantly. The most significant difference is that they create different future expectations. Dividends are often a regular, periodic payment. This means that when a company starts paying a dividend, they are often expected to continue doing so, and pay similar amounts each time. Share repurchases, on the other hand, do not create the same types of expectations in investors’ minds. This is a key difference that will impact if, when, and how companies choose to initiate a payout.

Beyond the individual circumstances of a given firms, the amount paid in dividends and repurchases changes over time due to market cycles and investor preferences. This is demonstrated by the change in payout levels from year to year represented in Figure 1. Table 1 demonstrates how the total amount paid in both dividends and share repurchases has changed from year to year for companies listed on the S&P 500. Stock repurchases tend to vary more in the amount of cash paid out, whereas dividends tend to hold steady.

Both payout methods are commonly used. In fact, many mature firms regularly use both. That being said, many firms prioritize one method over the other, or have chosen to only use one. The examples included below illustrate this point. The first example, Ford Motor Company, has regularly paid a dividend for many years. While Ford has initiated many share buybacks, dividends have been much more regular for the company. The second example, Google, has chosen to use only share buybacks as its payout method.

When to Initiate a Payout

A company’s payout method is based on several key factors. These factors influence both which payment method is used, and when payments are made. The form and timing of the payout will significantly impact how investors view the company—for better or for worse. Because of this, it is important for companies to understand which factors might influence these decisions.

Dividends in particular have been a theoretical conundrum for researchers for many years. In a perfectly efficient market, stock repurchases and dividends would be interchangeable or substitutable. However, this has never been the case in the real market. Instead, both seem to be used at different times or in different circumstances depending on a variety of factors. This apparent lack of coherency in the market has caused researchers to spend the last several decades developing theories that attempt to explain the various influential factors involved in deciding which form of payout to use, and when to do so.

Most of the theories that have been developed in academic studies and papers focus specifically on dividends, but we will compare and contrast how they might impact both payout methods. Several of these theories are detailed below. This list doesn’t attempt to be exhaustive, but does highlight many of the most prominent explanations.

Life Cycle Theory

Perhaps the most prominent and widely recognized payout theory is the life cycle theory. This theory predicts that a company’s stage of development will be a key determinant of both if and when a the make a payout. Many studies have shown that the more mature a company is, the more likely it is to initiate dividends. In these studies, maturity is quantified in terms of metrics such as profitability, available investment opportunities, degree of leverage, and overall size. In most cases, as a company matures, it will get larger, have fewer investment opportunities, and higher profitability. Because of this, the company will likely have larger and more consistent earnings, allowing for the initiation of a payout.

The two payout options are used at different stages in a firm’s progression because of the way each is perceived in the market. For example, dividends create an expectation for continued future dividends of a similar size. Share buybacks, on the other hand, create less of an expectation because they are often one-time deals. Consequently, in many cases, share repurchases are used more frequently following the IPO when the company is still less mature. One study in particular showed the following:

[Firms] use [share] purchases to pay out volatile cash flows, while they use regular dividends to pay out permanent cash flows. We find that those firms that have repurchased shares more frequently since their IPO are more likely to initiate dividends. Together, these results suggest that repeated repurchases are a sign that a firm is maturing and that its cash flows are stabilizing. Eventually, the firm switches to cash dividends as a means of paying out its excess cash flows.⁴

Life cycle theory rests on the idea that the tradeoff between earnings retention and distribution changes over time, eventually making dividends or stock repurchases more desirable than earnings retention. This happens when profits accumulate, investment opportunities decline, and the average investment return from dividends or stock repurchases becomes greater than retained earnings.⁵

Tax Theory

Another important payout initiation factor for firms to consider is that tax laws differ between payout methods. In an efficient market where all capital gains and dividends are taxed similarly, both forms of payout are equivalent to an investor. However, this is not the case in the real world. Instead, a variety of tax laws can make one payout method more attractive than the other. For example, the current laws in the United States tax capital gains at a lower rate than dividends, making share repurchases seem like the more attractive option in many cases.

Tax laws impact all potential or recent IPO companies in the same way. However, the choice of payout method could go either way depending on the company’s goals. In many cases, younger, less mature companies will choose to use share repurchases. This not only gives the firm’s investors a more tax efficient return, but it also allows the firm to maintain flexibility in how and when they offer payments. In fact, many companies have continued to use this method rather than turning to dividend payments, even when the company matures. However, dividends are still a relevant choice for many firms because many institutional investors face different tax laws than retail investors.

The difference in tax laws for institutional investors creates an incentive for some firms to offer dividends. Many large institutional investors, such as pension funds, colleges and universities, or labor unions, are largely or fully exempt from the same income taxes paid by normal retail investors, making dividends more attractive. Institutional investors are also commonly looking for cash generating investments, making dividends even more attractive. Because of this, many companies offer dividends specifically to attract institutional investors.

Attracting these large institutional investors has many potential benefits for a public company. Institutional investors have more capital, particularly if the company decides to issue a subsequent equity offering. Institutional investors also have better reputations for finding quality investments. When an institutional investor invests in a company, it can create increased exposure, a better reputation, and better valuations. One specific model put forward by academic researchers explains that when “institutional investors are relatively less taxed than individual investors, dividends induce ‘ownership clientele’ effects. Firms paying dividends attract relatively more institutions, which have a relative advantage in detecting high firm quality and in ensuring firms are well managed.”⁶

Depending on a registering company’s goals, tax laws will impact the payout type they choose to use. A company that wants to make a tax efficient, expectation-flexible payment to increase investor’s returns can use share repurchases. A company that wants to attract institutional attention and create better future equity raising opportunities might choose to offer dividends.

Transactions Cost Theory

Similar to tax theory, transaction cost theory attempts to explain the existence and persistence of dividend payments specifically. This theory posits that dividends exist in part because of the costs involved in transferring stock ownership. If the stock market were “perfect” in the theoretical sense, then there would be no cost to transferring ownership in a company, and stocks would be fairly valued. However, in the real world, many stocks are less liquid, meaning they do not trade in high volumes or without costs being involved. That is where dividends come into the picture.

Dividends can help owners of the company realize some profit from owning the stock, even when its shares are less liquid. One study showed that “in the cross section, firms with less liquid stocks (i.e., stocks with low trading activity, a high proportion of no trading days, and a high price impact of order flow) are more likely to pay dividends.”⁷ Other studies, since the publishing of these results in 2007, have reached the same conclusion, pointing to liquidity as one potential reason companies offer dividends.⁸

Companies that have recently gone public might face liquidity concerns for several reasons. These could include blackout periods, or lack of interest after a poor performance on the day of the IPO. In addition, smaller companies might face decreased liquidity due to lack of interest from investors, especially institutional investors. To address these concerns, a properly positioned company may choose to initiate a payout to raise value for the investors who own the illiquid stock.

Signaling Theory

Another contributing factor to the dividend initiation decision is signaling theory. Signaling theory is the idea that initiating a payout (specifically dividends) sends a positive signal to the market about the quality of the firm. Often, a payout is a sign that a company is doing well, making it a more attractive investment. One research study put it this way:

The firm is likely creating effects in two ways based on one model, and that is through the effect of the surprise of the [dividend] announcement itself, but also through the signaling of information about the persistence of future earnings. In other words, a firm has more information, and must be signaling that they are confident in the persistence of current or future higher cash flows.⁹

Sending a positive signal to the market can create confidence and greater opportunity to raise further capital. This is why researchers have found that firms that initiate dividends are also more likely to “issue seasoned equity in the near future.” Furthermore, “the greater the deficit in the firm’s level of institutional ownership, the greater is the probability that the firm will initiate dividends.”¹⁰ This evidence makes it clear that many companies are trying to send positive signals to the market in order to increase the future potential of equity offerings and attract and retain the interest of institutional investors.

In an IPO context, signaling can be very important. There are a variety of reasons that a newly-public company may need to better its reputation. These reasons could include lack of investor interest, poor stock price performance post-IPO, or volatile past performance. In these and other cases, the company may need or want to attract attention, or smooth stock price performance and signal the overall quality of the firm as an investment. In cases when the company is not properly valued, management may send a signal to the market that the company is doing well by initiating a payout. Initiating a share buyback can send a positive one-time signal, while a dividend can signal even more confidence in steady, large, future profits for the firm. Either way, management is demonstrating to the market that the company is worth a look from investors.

Catering Theory

Another important theory is referred to as catering theory. This theory posits that firms are more likely to initiate a dividend payment when the premium in the market for dividend paying stocks is high. Investors signal interest in and desire for dividends when they are willing to pay a premium. Thus, if companies become more willing to offer dividends during periods of high dividend premiums, they are effectively “catering” to the market. Research has produced evidence that catering is indeed part of the dividend initiation decision; one study reports that “we find firms are more likely to initiate dividends when the market premium for dividend-paying stocks is higher.”¹¹

When demand for a specific type of payout is high, it is possible that this will cause firms to consider a payout long before they normally would. This could cause even IPO-registering firms to initiate a payout at or shortly after the IPO. In 2013, during a period of high demand for dividends, one article reported the following:

In the past six months, nearly half of all companies that sold shares through an IPO, or 26 in total, have paid a dividend. Some are pretty big. For instance, Zais Financial Corp. (ZFC), a REIT that went public in early February, is expected to pay a dividend of $4.64 a year, for a yield of 22%. Its shares are up 5% since they went public.¹²

Other Factors

Both dividend payments and share buybacks are considered viable strategies for companies to add value for shareholders, but the payout method a firm chooses will be influenced by a variety of factors. For example, studies have shown that factors like the venture capital (VC) backing have an influence on the type of payout made. One study reported the following impact of VC backing on payout method and timing:

Further, the results indicate […] that VC backed firms are more likely to initiate post-IPO payouts through repurchases rather than dividends in an effort to signal the value of the firm and enhance valuations in advance of equity sales that help facilitate their eventual exit. […][The] results indicate that the time to dividend initiation is longer for IPO firms that receive VC financing and indicate a larger number of uses for the proceeds raised at the IPO. On the other hand, the time lag between the IPO and dividend initiation is shorter for more mature and profitable firms.¹³

Another factor is the planned use of IPO proceeds. If the company plans on investing a significant amount in growth and working capital, then it is also likely the firm will continue to retain the majority of earnings, and thus not commit to a regular dividend. The extent of competition in the market is another important factor. Companies that are facing high competition want to maintain the flexibility offered by stock repurchases given that the market views a reduction or elimination of stock repurchases as being much more acceptable than is a reduction or elimination of a cash dividend. The technological development of the industry is also an important factor. In high-tech, emerging industries, stock repurchases are more likely. On the other hand, industries that are relatively low-tech, developed, and mature tend to move towards dividends as the preferred payout method.

All the factors listed above are relevant for any company that is trying to build long term value for shareholders. These factors should be considered not only to ensure the correct payout strategy, but also to successfully compete in the marketplace. Understanding how each of these factors plays into the payout decision shows how important each of these factors is in the overall strategy of the company.

When Payouts Have Negative Consequences

While payout initiation usually creates shareholder value and sends a positive signal to the market, there are cases where it may not. If the payout isn’t coherent with the company’s strategy and isn’t representative of the company’s actual performance, it may send the wrong signal to investors. For example, one study found that “the market reacts negatively to post-IPO payout initiations by acquisition-oriented IPO firms.”¹⁴ In other words, if a company that planned on making acquisitions suddenly can’t find a suitable target, investors will devalue the company, even if the money is used to try and create value through a payout. That same is true if a company’s payout ratio isn’t in line with expectations. In other words, companies also need to make payouts that fall in line with their level of cash flow.

Paying a dividend can have some significant negative repercussions. As stated earlier, when a company starts paying a dividend, investors normally expect that it will continue to pay dividends from that point on. This expectation raises the value of shares. If a company that has been paying a dividend suddenly reduces or stops paying a dividend, this can cause share prices to fall dramatically.

Conclusion

Both share buybacks and dividends are generally beneficial to shareholders. These cash distributions increase investor confidence and send a clear signal to the market that the firm is doing well. However, the decision of which type of payout to use, and when to use it, is complicated. As detailed in our pre-IPO dividends article, and our IPO dividends article, many companies start offering a dividend before or even at the time of the IPO. Other companies have been public for many years, are well past the point of maturity, and still don’t pay a dividend. Because of this, companies should consider the impact that cash distributions, through cash dividends or share repurchases, can have on the valuation of the company. By using the right payout method at the right time, the company can both satisfy existing investors as well as maximize long-term value.

Resources Consulted

Allen, Franklin, and Gerald R Faulhaber. “Signalling by Underpricing in the IPO Market.” Journal of Financial Economics 23, no. 2 (August 1989): 303–23. https://doi.org/https://doi.org/10.1016/0304-405X(89)90060-3.

Baker, Malcolm, and Jeffrey Wurgler. "A Catering Theory of Dividends." The Journal of Finance 59, no. 3 (2004): 1125-165. Accessed May 10, 2021. http://www.jstor.org/stable/3694732.

Jensen, Michael C. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers." The American Economic Review 76, no. 2 (1986): 323-29. Accessed May 10, 2021. http://www.jstor.org/stable/1818789.

Kale, Jayant R., and Thomas H. Noe. “Dividends, Uncertainty, and Underwriting Costs Under Asymmetric Information.” Journal of Financial Research 13, no. 4 (1990): 265–77. https://doi.org/10.1111/j.1475-6803.1990.tb00631.x.