What is a Dividend Reinvestment Plan/Program (DRIP)?
A dividend reinvestment plan (“DRIP”) is where a dividend paying company allows shareholders to opt for receiving in-kind dividends instead of cash (receiving dividends in the form of additional shares).
For DRIPs that are administered out of treasury shares (the company issues new stock instead of purchasing it on the open market), this is dilutive to shareholders who do not participate in the DRIP.
For instance, if a company pays a 5% dividend, the hypothetical dividend would be 5% of a share. If an investor owns 20 shares, they would receive one full share. Fractional shares may be paid in cash or recorded.
For the purposes of this article, we discuss why a company would commence a DRIP program paying shares in kind.
Implementing a Dividend Reinvestment Plan and DRIP Participation
DRIPs are a useful tool should a dividend paying company want to preserve some of the cash that would otherwise be paid out to shareholders via their regular dividend program. Recall from our previous dividend post that dividends are perceived to be “sticky” and cannot be reduced without corresponding action from the investor base.
As it follows, a good time to implement a DRIP may be when a company’s leverage has become close to internal or external (Moody’s and S&P) credit thresholds or when it is undergoing a large capital expenditures program/other expansionary activity. DRIPs can also be a good idea when management perceives the share price to be overvalued – share dilution will also be muted due to the relatively low dividend yield.
As DRIPs are dilutive, when the company is on sound footing, the DRIP may be discontinued.
If a DRIP is appealing to company management, an investment bank will be hired to help implement the program.
To entice shareholders to switch from a cash dividend to in-kind payments, DRIPs should offer a discount to current share price. For instance, if a company is trading at $100 a share, the DRIP should be able to purchase it at a 2% discount or at $98 per share.
Theoretically, the higher the DRIP discount, the more participation there is in the program. Empirically, there is not always an uptick in participation when the DRIP discount is widened.
DRIP as Equity Financing
DRIPs may be a way to raise equity capital for the firm as opposed to a seasoned offering (which may be done through an agency/best efforts or bought deal).
In comparison to a bought or underwritten deal, DRIPs will usually have a lower discount on “selling” the stock. In underwriting, the investment bank will take on the risk of selling the stock to market participants and demand a discount (5-10%) that ensures that they will clear the trade and make a profit. DRIP discounts usually range from no discount to 5%. As such, DRIPs can be seen as a less dilutive equity financing option.
Of course, the cash flow timing of using a DRIP and a standard equity raise are very different. A share issuance results in immediate cash whereas the DRIP savings are spread out over time (they “DRIP” – ha ha… ha ha ha ha!). Unless the dividend and participation are substantial, it cannot be used reliably as a large funding mechanism.
DRIPs cannot be used for acquisitions when there is no existing cash on hand to pay for an asset. However, as alluded to above, DRIPs can be a good supplement to capital expenditure programs or mergers in terms of getting the company back onside from a credit standpoint.