Simply stated, capital allocation is what a company does with the profits and cash flows that it earns. It is a topic of significant discussion among public companies, but the importance of it is often overlooked by private business owners.
Most private companies are focused on sales growth and creating profits rather than on the decisions about what to do with them. Every company allocates its capital each year, but the key is whether the decisions about allocating capital are intentional or not. We often see companies get to the end of the year with profits but no cash to show for it. Sometimes this is because the company is a lifestyle business for the owners and all the money came out, whether or not that was good for the business. Other times, profit gets lost in the company’s working capital by having too much inventory that is turning slowly.
The reason capital allocation is so important is that those decisions are what principally drive value for shareholders by either efficiently deploying capital in a way that increases the company’s Return on Invested Capital (ROIC) or shareholder returns in the form of dividends. In simple terms, it means asking yourself whether you are deploying capital in a way that increases the value of the company and/or creates shareholder value through cash distributions to the owners. Additionally, if part of the company’s core values involves community or charitable endeavors, then meeting those values is also an important element of how capital is allocated.
Assuming that a company has net income and has adequately compensated its people, there is a relatively short list of options regarding a company’s capital allocation strategy, but each is very important.
1. Working Capital. This is often an area where capital is allocated very inefficiently due to not monitoring receivable and inventory turns. Allocations to working capital are critical to the business but the growth in working capital should be benchmarked to some standard and tied to the growth in the business. For instance, it is generally a bad sign if the business is growing at seven percent and inventory has grown by 17 percent. Every company should have clear metrics about how much is reasonable to invest in working capital to support the business. If the company is overinvested, it will reduce the ROIC, which is one of the key value drivers for the stockholders.
2. Maintenance Capital Expenditures. Maintenance capital expenditures are critical to the survival of any business and are unavoidable. A general rule of thumb is that, over time, one should expect to reinvest in plant and equipment at a level similar to depreciation expense. However, the most profitable companies we work with are very discerning about these expenditures and making sure that they squeeze out every ounce of productivity from their existing plant and equipment before investing more.
An example is deciding whether to maintain or refurbish a piece of manufacturing equipment versus replace it. Another example is replacing an old piece of equipment with a new one with the latest technology bells and whistles. While the new piece of equipment can likely produce goods faster, the question is whether the additional spend for that efficiency is worth it. Allocating capital here is unavoidable but determining how to efficiently use what a company already owns is a critical part of the decision.
3. Growth Capital Expenditures. Deciding to deploy capital on new initiatives, ventures, and businesses is an exciting part of how a company can achieve its growth goals. However, this can be an area where a lot of capital needs to be allocated to a new initiative but the analysis of the return on capital is not properly developed. We suggest creating models to assess the cost of new initiatives versus the after tax cash flows associated with them to ensure that the company is deploying capital to get the proper ROIC. Whether you use an internal rate of return calculation, payback period, or a similar measure, it is important to have methodologies to determine the financial returns associated with the expenditure. Generally, when the ROIC is greater than the company’s cost of capital, the value of the company is being enhanced. Likewise, if the ROIC is below the company’s cost of capital, value is being destroyed and it is best to deploy the funds on a better opportunity.
4. Acquisitions. Decisions about buying another company don’t happen often, so this is an area to proceed with caution. Like the discussion above regarding growth capital expenditures, acquisitions should be assessed based on whether the ROIC exceeds the company’s cost of capital. Done properly, they can enhance the company’s value and growth prospects. We have seen some mistakes when companies fall in love with a deal and chase it at any price.
We suggest two very important things when considering acquisitions. First, model the outcomes conservatively and don’t overestimate synergies without considering what could go wrong. Second, maintain discipline about what you are willing to pay and walk away if the seller’s price is too high. Unless the acquisition is a “save the company” situation, most companies will continue to operate well with their existing business if the acquisition does not happen. Therefore, it is not worth overpaying and absorbing capital in an opportunity with a low yield and high risk.
5. Debt. This category of capital allocation usually is first in line because the company has contracted payments with a third party that it must make. However, you should always be assessing the level of cash flow committed to debt service, the cost of borrowing and the overall debt level on the balance sheet, and whether the company is over or under leveraged. Too much debt can hinder a company’s growth because high interest and principal payments are absorbing too much income and that money isn’t available for other projects. On the other hand, the smart use of leverage can enhance returns because borrowing at reasonable amounts and rates can allow the company to grow faster so long as the balance sheet can handle the debt levels. Assessing the company’s debt situation is an important conversation and a significant part of a company’s capital allocation strategy.
6. Stock Redemptions. Shareholder transactions in private companies don’t occur often but should be part of your annual capital allocation planning. This is especially true in family companies with shareholders who are not active in the business. Often those shareholders may not receive adequate dividends and their shares are not marketable to the public so they see no value in holding them, especially if they’re not involved in the daily operations of the business. On the other hand, those shareholders actively engaged in the business may be interested in having more ownership in the company and may want to benefit from their efforts in driving the company forward. These topics should be discussed at least on an annual basis and may be important to plan for capital to be allocated to it.
7. Dividends/Wealth Distributions. We see varying practices when it comes to dividends, from companies that distribute nothing to companies that take out too much. Striking a good balance here is important for two reasons. First, shareholders take significant risk in holding private company stock and should receive some return on their capital in the form of a dividend. Second, we see many private owners who approach retirement age with all their wealth tied up in their company stock and they have not allocated any capital to their personal balance sheet to develop other forms of wealth such as an investment portfolio. This issue presents a lot of risk to many owners since a private company is a risky proposition and is illiquid unless the business is sold. Every owner should have a personal wealth plan that is part of their capital allocation strategy for the business and should have a strategy to distribute profits out of the business at reasonable levels to give them a return and allow them to diversify their holdings
8. Community/Charity Investments. One of the great things about being a private company is that the owners answer to themselves and their own business goals and objectives. Another area to include in a private company’s capital allocation strategy is community investments and charitable giving. This is more about meeting shareholder values than creating shareholder value. Every company does this differently, but if allocating resources for the good of others is important to the company and part of its core values, then it should be an important element of how capital is allocated.
Capital allocation for private companies has a lot of moving parts and variables. We believe that the most important issue is to identify your choices are and develop an intentional approach specific to your company. In our experience in modelling capital allocation scenarios, it is amazing to see how quickly one dollar of after-tax earnings can disappear when you consider all the options regarding what to do with the money. Making it a regular part of management’s attention and being intentional and thoughtful about it will drive shareholder value and values for the long term.
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