Limitation on dividend distributions is one of the clauses that often creates a friction between a bank and a company.
The ideal position for the bank is to limit dividend distribution altogether, because it is worried that the financial standing of the company could deteriorate and that it might not be able to recover its loan.
On the other hand, the company’s ideal position is to have maximum freedom to decide if, when, and how much should be paid to owners / shareholders.
These two positions are the extremes, and if the two sides cannot agree, it can be a dealbreaker.
However, there are solutions how to find a middle ground.
For example, here is what you can do:
1 Link the permission to pay out dividends to a financial ratio
The bank is normally worried that the leverage level might spiral out of control, so it would make sense to introduce a ratio like Net debt / EBITDA, DSCR, Cash / ST debt, or Debt / relevant cash flow metric. Alternatively, there is also the equity ratio, but it can be tricky because it is completely delinked from the company’s cash flow generation and liquidity.
The idea is to allow the company to pay out dividends if its leverage level remains below certain level, but when selecting an appropriate ratio, one should not forget the liquidity aspect of the company.
It is also important to properly define the ratios, as the wrong definition can lead to irreparable damage.
2 Set the limit to dividend payout
This can be an absolute limit like EUR X million per year, or it can be a relative limit like X% of the company’s prior year net income.
This is a good way to impose some restrictions, but the downside is that the results could be manipulated and the limits (either abs or relative) inappropriate for the whole duration of the loan. It is important here to make sure the financial projections are of a good quality.
3 Mix solutions 1 and 2
It is possible to combine the solutions 1 and 2. For example, if Net debt / EBITDA is below 2x, the company can pay out 100% of its profits. If Net debt / EBITDA is between 2x and 3,5x, the company can pay out 50% of its profits. If Net debt / EBITDA is above 3,5x, the company cannot pay out profits.
It works perfectly because it recognizes the company’s needs to have some freedom, and it restricts the company in case the results are not good.
In any case, don’t forget the stipulation that the dividend payout should not lead to an event of default.
Which level will be negotiated depends on the company’s financial position, negotiating power, loan maturity, and the type of a banking product.
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