Capital allocation is one of the most important – and most widely disregarded – issues in family-owned businesses. Most companies pay a great deal of attention to how to earn profits but very little attention to what to do with
those profits. Making intentional decisions about how to allocate your company’s capital is critical to ensuring the future of your company and maintaining harmony among family shareholders.
This issue is especially important for family businesses with both active and passive shareholders because the lack of a clear capital allocation policy can create conflict. With no clear dividend or redemption policy, passive shareholders may have an illiquid investment unless the company is sold, which is contrary to the legacy interests of most family businesses. Their need for a return on their investment or the ability to redeem their shares runs contrary to those
family members working in the business who need to retain capital.
Without a thoughtful, clear policy that addresses all of the company’s and shareholders’ capital allocation needs, “dividend friction” often
develops. That friction can fracture family relationships. However, whether you reinvest or distribute capital, all family shareholders should benefit if the decisions are thoughtfully made and consider the best interests of the business and shareholders.
In establishing a capital allocation policy, the health of the business has to come first since no one wins if the business does not continue to thrive. While the specifics of a capital allocation policy will vary greatly depending on the business, the following construct can be used as a guide.
- Taxes: Make no mistake, we believe every company should have a good tax strategy. The reason taxes are first on this list is that making distributions for taxes is not a choice and taxes are a significant claim on cash flow that limits the amount of money that can be used for other things. At a minimum, it is a good practice to help shareholders understand that a dollar of earnings is not a dollar the company keeps. After taxes, there is a lot less capital to allocate among the other important items listed below.
- Liquidity Buffer: We believe it is a good practice to set aside some portion of annual earnings to provide a capital and liquidity buffer for the business. Since private capital is scarce and expensive, some level of “dry powder” is important to maintain as insurance against unexpected, adverse business events or a downturn.
- Debt: Maintaining reasonable debt levels is a critical factor in a company’s capital allocation strategy. Paying down more debt than scheduled or paying down lines of credit should be an important annual capital allocation decision since it can lower the company’s interest cost and leverage (risk). Also, a dollar of debt reduction is a dollar of increased value to the shareholders.
- Working Capital: A lack of working capital can jeopardize your company. However, many companies don’t have policies to manage
working capital levels efficiently; this is often an area of significant waste. Working capital investments should correlate with a company’s growth rate. - Fixed Assets: Fixed asset investments are the engine that drives a company’s growth over the long term. Proper fixed asset investments should increase shareholder value over time so long as they are made wisely. Establish a “hurdle rate of return” on fixed asset investments to ensure that they are a prudent use of capital.
- Strategic Projects: Any capital allocation plan should give consideration to large-scale, non-recurring investments like an acquisition or large plant expansion. This is where a company’s capital allocation plan intersects with its strategic plan. If there are strategic initiatives that have to be funded, capital needs to be set aside for them.
- Profit Distributions/Dividends: The decision to distribute profits to shareholders is difficult because it has to be considered without jeopardizing the company’s future. However, shareholders do deserve a return on their capital at a level that does not negatively affect the company. We suggest establishing profit distribution limits that are either based on a percentage of the company’s equity or, more commonly, a percentage of the company’s profits after tax distributions.
- Stock Redemptions: Allocating capital to stock redemptions should be done with caution since they can be large and costly. We typically advise establishing an annual percentage cap based on after-tax profits to be allocated to all shareholder payments, including profit
distributions.
Establishing a capital allocation policy in a family business is a complex but necessary exercise. If properly constructed and communicated, the company and its shareholders should benefit in the long-term and family relationships should remain intact.
Mario O. Vicari can be reached at Email or 215.441.4600.