A distribution can be prudent, affordable and approved by a board, and still be wrong. Paid when the company's debts exceed its assets, it is in many jurisdictions unlawful and recoverable. It can breach a restricted-payment clause in the loan agreement and put the facility in default. It can be split among the owners by what everyone remembers instead of what the documents say. Or it can leave out the tax distributions that owners of a pass-through business rely on to pay tax on profit they have not received, which then get improvised in April.
Each of these surfaces eventually, usually at the worst moment: when a buyer's counsel reads the distribution history, when an owner leaves on bad terms, or when a creditor looks for money to recover.
Distribution Mechanics prevents them. Under a written owners' agreement, each payout is lawful, correctly allocated and complete for tax, so the declared figure is what each owner actually receives and nobody has a claim against the business later.
Where Distribution Mechanics sits
Three drivers turn a payout into a promise. This essay covers the third.
FCFE less reserves
- Distribution PolicyTurns the payout into a ratio sized to a stress case, with cut and restore rules written in advance
- Board GovernancePuts each distribution before a board with an independent member, with its four tests attached
- Distribution MechanicsThis essayMakes each payout lawful, correctly allocated and tax-complete under an owners' agreement
Declared distributions
An agreement that governs every payment
The basis is an operating or shareholders' agreement drafted by counsel. It sets the distribution waterfall, the classes of ownership and their rights, the restrictions on distributions and the tax distributions, and every distribution in the history must have followed it.
Counsel starts by reviewing the existing agreement against the distribution policy. Most owner-run businesses have an agreement, often signed at formation and rarely read since, and it frequently conflicts with how the business actually pays its owners: a preferred return that has been ignored, a class of shares with rights nobody remembers, a requirement for unanimous consent that has never been sought. Each conflict with the policy is listed and resolved by amendment, all owners sign the amended agreement, and the waterfall goes into the distribution file as a worked example.
Walking the waterfall
Illustrative, for an agreement that pays tax distributions first, pro rata, then a fixed preferred amount for the period on one class, and shares the remainder by ownership. The worked example in the distribution file does this for every owner, every period.
In the illustration, a declared $333,200 pays $90,000 of tax distributions first and $50,000 to the preferred class, and the remaining $193,200 is shared by ownership, so an owner of 40 percent of the common receives $113,280, $36,000 of it as a tax distribution.
The worked example earns its place. Only counsel can apply a waterfall written in legal language. Worked through with real numbers, from the total declared to each owner's share, it becomes something the finance lead can apply every quarter and the owners can check, and an allocation the owners can check is one that holds up when they disagree.
A legality test before money leaves
Every distribution file should hold a solvency test under the law that governs the business, and a covenant and restricted-payment check under the credit agreement, with the lender's consent where the agreement requires it.
Counsel writes the test once, as a one-page form the finance lead completes each time, carrying the thresholds the law and the credit agreement set. The solvency test asks what most jurisdictions ask in some form: whether the business can pay its debts as they fall due after the distribution, and whether its assets will still exceed its liabilities. The restricted-payment check asks whether the credit agreement allows the payment, which usually turns on the covenant headroom left after it.
The covenant check then goes to the lender with the compliance certificate, so the lender's file and the distribution file agree. A lender that learns of a distribution from the business's own certificate, test attached, has no reason to object. One that learns of it from a bank statement has every reason to.
May this payment leave?
The legality test counsel writes once and the finance lead completes before every distribution, in order. The first check that fails stops the payment.
With the test signed before every payment, no payment can be clawed back, and the buyer has one less uncertainty to price.
Tax distributions, computed and paid
Tax distributions should be computed by the agreement's formula, paid by the dates it sets, and reconciled each year to the owners' tax statements with any true-up recorded, over several consecutive years.
They exist because the owners of a pass-through business are taxed on its profit whether or not they receive it. If the business retains profit to fund reserves and growth, the owners still owe tax on it, and the agreement usually provides for the business to distribute enough to pay that tax. Where there is no formula, tax distributions are improvised, estimated in a hurry, paid unevenly and rarely reconciled, so some owners receive more than their tax and others less.
The fix is to compute them quarterly with the outside accountant, on estimated taxable income at the rate the agreement sets, and to reconcile at year end against the owners' tax statements when they arrive, recording the true-up. Because the policy counts tax distributions as the first part of the payout, they never become a hidden deduction from the business's cash.
Why the mechanics matter more on this bridge
A buyer of a controlling stake may not care much how past distributions were allocated, since it will replace the owners. A yield buyer, or a family that means to hold the business for a generation, cares a great deal, because it is buying into an arrangement among owners that continues after it arrives. If that arrangement has been followed loosely, the new holder inherits every open question: whether a past payment was lawful, whether an owner was underpaid, whether a class of shares has rights that were never honoured.
For the same reason the agreement is reviewed whenever ownership changes. A death, a divorce, an exit or a new owner each changes who is party to it, and each is the moment a loose arrangement turns into a dispute.
How a buyer's counsel reads the files
A buyer's counsel works through the distribution files one at a time. They look for a signed legality test dated before the payment, and compare the covenant check with what the lender was told in that quarter's compliance certificate. They match each owner's receipt against the waterfall in the agreement in force at the time, and confirm that tax distributions were paid on the agreement's dates and that the year-end true-up reconciles to the owners' tax statements.
A file that answers all of that is read once and set aside. A file with a payment and no test, or a split that does not match the agreement, becomes a matter for the seller's representations. Counsel will ask for a specific indemnity against claims arising from past distributions, and the seller will carry it for years after the sale. Several years of complete files are what let the seller give the ordinary representations instead.
What it does to value
Distribution Mechanics ranks ninth on the bridge. Its value is the removal from the downside scenario of the probability of a clawback, or of a dispute among owners over allocation, multiplied by the distributions exposed and discounted. For most businesses that probability is small, which is why the driver ranks low. When it does materialize it is expensive, which is why the driver still gets done.
The finance lead is paid on a simple test: every distribution with a completed legality test and every tax distribution paid on the agreement's dates, or nothing.
What has to be in place first
Counsel has to be engaged and budgeted for the agreement and the legality test before the review begins. The distribution policy has to be adopted first, because the agreement is aligned to the policy and not the other way round. And the outside accountant needs the quarterly tax computation and the year-end reconciliation written into its scope letter.
Knowing that it works
The driver is tracked by the share of distributions paid that carried a completed legality test, which should be all of them; by late tax distributions, counted against those due; and by conflicts between the agreement and the policy still outstanding, which should be none.
The owner can be tested by walking the waterfall for the last distribution, from the total declared to each owner's share, using the agreement and nothing else, and by reading the last legality test and naming its thresholds, the solvency measure and the covenant level, in numbers.
Why it slips, and what holds it
The driver fails when a payment is urgent and the test is skipped, so that a distribution goes out in breach of a covenant, a solvency test or the agreement. It also fails when a death, divorce or exit arrives and the agreement and the buy-sell turn out to be out of step.
The bank instruction answers the first: it requires the signed legality test as an attachment, so no payment leaves without one. Counsel's review at every change of ownership answers the second, with the agreement and the buy-sell checked together each time so that neither drifts from the other.