While the term “capital allocation” is often associated with public companies, we feel it is a more important issue for a private company. However, in our experience, many private companies view their capital allocation decisions too simplistically.
Financially speaking, the goal for any company is to earn a profit that represents an adequate return on its invested capital. Most companies focus the majority of their time on this issue – and rightly so. But capital allocation represents happens next; i.e., what a company should do with the capital it earns. This decision is critically important to the company’s strategy and its shareholders.
It is especially important for private companies that are dealing with capital that is scarce and expensive, as opposed to public companies with access to capital that is abundant and cheap. Another important difference is that a private company’s stock usually represents the largest asset on the owners’ personal balance sheets. For them, being thoughtful about what to do with the company’s earnings is a very big deal.
The capital allocation discussion often arises at year-end, when owners need to decide how much money to take out or leave in the business. Most tax advisors approach this situation with a singular focus on lowering taxes, often without giving consideration to other important issues related to the company’s capital allocation. We think this approach is significantly flawed because while it is important to manage taxes, it should not detract from the company’s strategy and properly funding the business for the long-term. It amazes me when I hear about companies spending $100,000 on a piece of equipment they don’t need for the sake of saving $40,000 in taxes. Wouldn’t it be better instead to have $60,000 in cash that can be properly be deployed in the business or distributed?
Our work has increasingly involved helping private companies craft a capital allocation framework, particularly in multi-generational companies where there may be passive shareholders who are more interested in distributions or redemptions of stock and less in re-investing in the business. Balancing these priorities is often difficult, but it can become a real detriment to the business and its shareholders if there is not a well thought out framework in place.
Here are some high level considerations when thinking about capital allocation in your business:
- Taxes: Make no mistake, we believe every company should have a good tax strategy. But it should not get in the way of good business. The reason this consideration is listed first is because paying taxes is not a choice. For every $1 in earnings, you are left with just $0.60 after distributions are made to the stockholders to pay taxes. That leaves a lot less of your company’s earnings to allocate among the other important considerations listed below.
- Debt: Maintaining reasonable debt levels is a critical factor in a company’s capital allocation strategy and requires an allocation of the company’s earnings. It’s listed second because existing debt commitments represent a portion of a company’s capital that cannot be allocated for other uses.
- Working Capital: Working capital is next because a lack of investment in it can put a company in a liquidity trap and the business in jeopardy. Every company has to invest in working capital at a reasonable level if it wants to grow. Inefficient investment in working capital will diminish shareholder value over time.
- Fixed Assets: While not a requirement like taxes or debt service, fixed asset investments are the engine that drives a company’s sales over the long term. Without proper maintenance and reinvestment, a company will eventually diminish its ability to maintain its sales, let alone grow. It is a good capital allocation practice to finance portions of fixed assets with a reasonable level of term debt, since the period of benefit is longer-term. Proper fixed asset investments should increase shareholder value over time.
- Profit Distributions/Dividends: The decision about how much to “take out” vs. “leave in” is one of the toughest for a private company. Shareholders do deserve a return on their capital, but deciding how much that return should be is difficult in light of the first four considerations. Paying down debt and reinvesting in working capital and fixed assets should all drive improved shareholder value over the long term. However, it is reasonable for shareholders to get some annual return for leaving their capital at risk. We feel that it is best to establish a policy for this, particularly when there are both active and passive shareholders. Typically, we would suggest establishing reasonable limits to the level of profit distributions based on either a percentage of the company’s equity or, more commonly, a percentage of the company’s profits after tax distributions. Certainly, this policy needs to be consistent with a company’s bank covenants.
- Redemptions of Stock: Stock redemptions are increasingly a policy decision for companies with passive shareholders. If you are a shareholder of a private company with typical transfer restrictions, your stock is illiquid unless the company is sold. Taking into account the personal liquidity needs of shareholders while not overcommitting the company’s capital is an important balance to strike when allocating capital to stock redemptions. While specific policies will vary, we generally advise establishing an annual limit (usually in conjunction with a limit on profit distributions) based on the company’s after tax earnings or a specified dollar amount. This provides some liquidity options for shareholders while protecting the company.
Hopefully this demonstrates why the capital allocation discussion is more complex than most private companies realize. And the limitations on access to capital make these choices tougher. At Kreischer Miller, we have used these considerations as a general framework in our work with private companies. Of course, the details are specific to each company’s unique business, capital structure, financial condition, and shareholder needs. But the bottom line is that developing a capital allocation strategy is important for every private company and worth the investment in time to develop clear policies that will guide the business forward.
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