Dividend Cover: Striking the Right Balance for SMEs in Transition

For many SME owners, dividends have long been the preferred way of paying themselves. Dividends typically attract lower rates of personal tax than salary, and they can be more flexible — declared when profits allow, rather than as a fixed monthly cost. But as a business grows and matures, relying solely on dividends isn’t always the best approach.

A key concept that underpins dividend decisions is dividend cover. For SMEs preparing to move from “owner-managed” to a more structured, investor-friendly model, getting this right can make all the difference.

What is Dividend Cover?

Dividend cover is the ratio of a company’s post-tax profits to the dividends paid out.

• A cover of 1 means all profits are distributed as dividends.

• A cover of 2 means only half the profits are distributed, with the other half retained.

Think of it as a measure of how sustainable your dividend payments are.

The Owner’s Perspective

Low Dividend Cover (around 1× or less)

Pros:

• Maximises cash in the owner’s pocket.

• Efficient in the short term if personal tax is the main consideration.

Cons:

• Leaves the company with no buffer — no reserves for reinvestment, unexpected costs, or downturns.

• Makes it harder to recruit a replacement MD or senior manager on a proper salary, since the company is geared around funding the owner personally.

• Looks unattractive to investors who want to see financial discipline.

Higher Dividend Cover (2×–3×)

Pros:

• Builds up retained reserves, which can fund growth, acquisitions, or weather tough years.

• Shows discipline and sustainable planning, which makes the company more attractive to lenders and investors.

• Allows the business to start paying a proper market salary for the owner’s role, making it genuinely replaceable.

Cons:

• Reduces immediate cash to the owner.

• Creates a short-term personal tax disadvantage compared with dividend-heavy models.

Blanket vs. Tiered Dividend Policies

When thinking about dividend cover, there are two broad approaches:

Blanket Policy (fixed cover level, e.g. 2×)

Pros:

• Simple to administer and explain.

• Creates consistency and predictability for shareholders.

• Strong signal to investors of discipline and stability.

Cons:

• May feel rigid — owners could miss out on extra rewards in unusually good years.

• Can build up reserves faster than needed, leading to “lazy capital” sitting on the balance sheet.

Tiered Policy (underpin + special dividends)

This approach sets a baseline policy (e.g. cover of 2× retained every year) but allows additional dividends for specific “wins” — such as major contract completions, asset sales, or windfall profits.

Pros:

• Retains the stability of a cover policy while rewarding exceptional performance.

• Keeps reserves at a healthy level but avoids over-hoarding cash.

• Aligns shareholder rewards with genuine business achievements.

Cons:

• More complex to administer — requires judgement calls about what qualifies as a “special win.”

• Can create pressure from shareholders who push for “specials” too often.

• Risk of undermining the baseline policy if exceptions become the rule.

The Investor’s Perspective

Potential investors want to see stability and headroom:

• A dividend cover of 1× or below suggests the business has little capacity to cope with profit volatility. It’s high-risk.

• A cover of 2× or above suggests the company is retaining profits sensibly and is committed to long-term growth.

• Investors also view dividend policy as a signal of management maturity. Paying all profits out implies the business is still owner-lifestyle driven, rather than investor-ready.

• A tiered approach, if applied carefully, can look attractive to investors: it demonstrates prudence (baseline cover) but also flexibility (rewarding true outperformance).

The Transition: From Dividends to Salary

When an SME owner moves from taking most of their income via dividends to drawing a proper salary, it changes the company’s financial shape:

1. Salary becomes a fixed cost – future managers or successors can be paid without destabilising cash flow.

2. Dividends become a true return on capital – not just a tax planning tool.

3. Dividend cover becomes a discipline – helping balance personal returns with retained earnings.

The shift may feel like a pay cut in the short term, but it professionalises the business and increases its value to outside investors or buyers.

Building a Dividend Policy

For SMEs in transition, a few principles help:

• Target a cover of at least 2× to demonstrate resilience.

• Choose a policy style – blanket (simple and clear) or tiered (balanced but more complex).

• Use retained reserves strategically – not just as a rainy-day fund but as capital for expansion, acquisitions, or debt reduction.

• Communicate clearly – both internally (to directors/shareholders) and externally (to investors) about how dividend policy aligns with growth plans.

• Phase the shift – gradually increase salaries and reduce dividend dependency over a few years to ease the tax impact.

Conclusion

Dividend cover is more than just a financial ratio. It’s a reflection of how an SME balances today’s rewards with tomorrow’s opportunities. For owner-managers, moving away from heavy dividend reliance towards a sustainable salary-plus-dividends model can feel uncomfortable — but it’s often the necessary step to build a company that’s investable, resilient, and truly able to outlive its founder.

The choice between a blanket policy and a tiered approach comes down to simplicity versus flexibility. Whichever route you take, the key is consistency, transparency, and a focus on the long-term health of the business.

If you would like help setting a dividend policy please contact Peter.Searle@ba4cs.co.uk