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In his book, The Outsiders, William Thorndike makes a comprehensive and compelling case that effective capital allocation is one of the most important skills that any CEO can possess in their pursuit of value creation. Some very influential people seem to agree, with both Warren Buffett and Charlie Munger including Thorndike’s book within their respective “must-read” lists.
In my interview with him for the In The Trenches podcast, Jordan Bettman, Co-founder and Partner at Radian Capital, suggested that the three most important jobs of any CEO are i) Mission, Vision & Values; ii) Strategy; and iii) Capital allocation.
Relative to its apparent importance however, capital allocation seems to be a relatively under-discussed subject among CEOs and entrepreneurs, particularly among those running SMBs. The subject is at least as important as more common day-to-day issues like hiring, culture, or compensation, though it rarely seems to occupy the same share-of-mind. This is an important oversight, and one that I fell victim to when running my own company, even in spite of my background as an investor. Though capital allocation wasn’t a discipline that I ever consciously or explicitly deprioritized, it often lost the battle for my time and attention when competing with more common day-to-day issues like those mentioned above. In retrospect, I wish that it hadn’t.
Regardless of whether your company has taken (or is seeking to raise) external capital, as a CEO you’d be wise to regularly look at your business through the lens of an investor to ensure that you’re allocating your company’s scarce financial resources towards their highest and best use. What follows are some relevant lessons that I’ve collected over the years related to capital allocation, some of which I hope are helpful to you:
First, a Definition
Capital allocation refers to how and where a CEO decides to deploy her company’s financial resources between five primary uses: i) Repaying outstanding debt, ii) Repurchasing shares; iii) Paying dividends; iv) Acquiring other businesses; or v) Re-investing in company operations (which in itself can assume countless different forms).
The CEO as “Chief Investment Officer”
Whether you know it or not, if you’re a CEO, you’re also your company’s Chief Investment Officer. This is because any time that you spend a material amount of money on anything (from new hires, to product R&D, to repaying your bank loan), you are making an investment decision. And as with any investment decision, the goal should be to maximize your risk-adjusted rate of return relative to other potential uses of that capital.
Though that may sound obvious to you intellectually, in practice many SMB CEOs make two critical oversights that inadvertently ignore this reality:
- They Don’t Quantify the ROI of Material Company Expenditures: These CEOs tend to be quite reactive, and tend to allocate capital to problems and opportunities as they arise in the ordinary course of business. For example: A competitor releases a new product, so you automatically begin funding efforts to release a similar product to maintain competitive parity.
- They Don’t Compare the ROI to Other Potential Uses of That Capital: Even for CEOs who do quantify the ROI of material company expenditures, the most common oversight is to not compare that ROI to other potential uses of that same capital. For example: A 15% rate of return on a $1M investment in a new product may sound attractive on the surface, but it may not necessarily be so if that same amount of capital can generate a 20% rate of return through share repurchases (all else being equal).
Even for CEOs who manage to avoid both of these oversights, questions of capital allocation rarely present unambiguously clear answers. Most of the time, this uncertainty stems from the fact that:
a) Each major use of capital presents a different risk/return profile; and
b) The returns specific to each use of capital aren’t equally easy to quantify, as profiled below:
v) Re-Investing in Company Operations: In many cases, it is re-investing in company operations that presents CEOs with the most difficulties as it relates to capital allocation. In part this is because it is an enormously broad use of capital that can encompass thousands of possible variants (as it essentially refers to any expenditure made in the course of operating your business), but also because in many instances, ROI is particularly difficult to forecast and quantify in comparison to the other 4 major uses of capital. These difficulties are compounded by the fact that decisions in this category are usually made on a daily or weekly basis, whereas decisions related to the other 4 major categories tend to be made less frequently (monthly, quarterly or annually).
Though there isn’t necessarily a silver bullet that can directly address all of these difficulties, there is a simple two-step process that you can establish to ensure that your company, at the very least, applies an appropriate level of rigor and discipline to capital allocation decisions that fall within this category. Looking back on my own time as a CEO, I regret nearly every instance in which I approved a major company expenditure without subjecting it to the rigors of this simple two-step process.
Step 1: Quantify Everywhere Possible
To ensure that you avoid falling victim to the first major capital allocation mistake, you should ensure that a projected ROI analysis is attached to every request for a material company expenditure, whether that request comes from yourself or from somebody else within your company.
Though what constitutes a “material” expense will differ from company-to-company, it’s important that you establish a materiality threshold to ensure that minor expenses (office supplies, client meals, etc.) aren’t stifled by unnecessary process and bureaucracy. Any expenses over-and-above this threshold should automatically be funneled into the process before they are approved.
Some expenses will naturally be harder than others to quantify, however it is precisely these types of expenses that most need to be subjected to the rigors of this process. Take, for example, hiring: Though the cost of a new hire is simple enough to understand, managers often struggle to assign quantifiable benefits to new hires, and (potentially as a result) usually opt for more qualitative justifications like “our current team is too swamped” or “if we don’t hire somebody else in customer support, we’re likely to lose some of our major clients”. Though qualitative considerations like these shouldn’t be ignored, in and of themselves they represent insufficient rationale to justify a major investment like that of assuming a new salary.
As a CEO, one thing that I learned very quickly is that it’s incredibly easy to throw bodies at problems: In the moment, approving hires makes you feel as if you’re doing something to address a pressing problem, but over time, I came to realize that requests for new bodies were often just symptoms of much broader, more deeply-rooted problems, for which hires weren’t particularly effective in solving. It’s also important to remember that it’s very easy to add employees, but very difficult to subtract them if circumstances eventually compel you to do so. Every hire that you make without the required level of thoughtfulness and deliberation incrementally increases this “over-hiring” risk.
Forcing managers to assign a business case (by way of an ROI analysis) for difficult-to-quantify investments like new hires will present your company with a few major benefits:
- First, it gets employees and managers in the habit of thinking like investors, something that most won’t be used to doing. Even if their expense requests aren’t approved, or even if the benefits stemming from the expenses are difficult to quantify, with enough repetitions over time, employees and managers will naturally begin to apply their “investor lens” when contemplating material company expenses, a benefit that can’t be overstated.
- Second, the discipline of having to quantify benefits can, in some cases, prevent you from making an emotional decision that ultimately won’t solve the problem in question. Again, consider a hiring example: Instead of hiring a software engineer because you have more good ideas than engineers to build them, ask yourself: What am I going to get in return for the salary that I’m paying this person? Will we bring product X to market faster? If so, how much incremental money will that yield relative to the salary that I’m being asked to pay? Will we have enough bandwidth to finally add feature Y? If so, how much incremental revenue will that create, and how does that compare to the salary that I’m being asked to pay? Will we finally build feature Z for our largest customer who is threatening to leave for a competitor? How much lost revenue will that save for us, and how does that compare to the proposed salary? And so on.
Step 2: Compare the ROI Above to the ROI of Other Potential Uses of Capital
As mentioned above, an ROI of X% for a given use of capital may not necessarily be the best use of money if you can achieve an ROI that is higher than X% by putting that capital to a different use entirely. In order to make such comparisons regularly, the CEO must ensure that she has a deep understanding of her company’s cost of capital (a topic that is beyond the scope of this blog post, but about which much has already been written), as that is a central consideration in each of the 5 major uses of money, but particularly in uses i, ii, and iii. As I write this in September, 2022, cost of capital considerations have now become particularly important in light of the rising cost of debt witnessed over the past ~6 months.
It’s important to acknowledge here that while the results of the quantitative analysis are essential, there is still room to contemplate qualitative or strategic considerations that are seemingly in conflict with them. For example: Though investing in a new software product may yield a 20% return on your money, you may still choose to invest your capital in fixing the shaky back-end architecture of your existing products (an investment of time and money that is harder to quantify and is less likely to yield incremental revenue) if the new customers that you would have acquired through the release of that new product would crash your entire system.
Don’t Lose Sight of Your “North Star”
As it relates to capital, some CEOs have a “north star” that can become easy to accidentally ignore over time, but I urge you to fight this tendency by always keeping it top of mind. For example, the “north star” of some public company CEOs may be to maximize their company’s price per share (whether or not one agrees with that north star is besides the point for purposes of this article). In my case, as somebody who took external capital from equity investors and had an explicit mandate to return it back to them with a suitable return, my “north star” was to provide my investors with the best possible risk-adjusted return on their investment.
Though that sounds simple enough, with enough time in the weeds of the day-to-day business operations, I allowed my “operator lens” to cloud my “investor lens” in such a way that I sometimes lost sight of my north star. Looking back, I wish I had kept this north star more central in my thoughts, as it’s now clear to me that I would have been better off repurchasing shares or paying dividends (capital uses #2 & 3) instead of pursuing some of the internal growth initiatives that I did (capital use #5).
Whatever your north star is, make sure you never lose sight of it.
“Revenue is vanity, profit is sanity, cash is king”
No discussion about capital allocation would be complete without a discussion of cash, as, in a way, simply keeping cash on your balance sheet can be considered a sixth potential use of capital, in addition to the five that I’ve already mentioned.
“Cash is Trash” (…until it isn’t)
People who subscribe to the purely academic view of cash may point to the fact that, unlike the five major uses of capital discussed above, cash sitting on the balance sheet provides companies with no return on investment, and indeed loses value to inflation with each month, quarter, or year that passes. These people may argue that a large cash balance is a sign of a CEO with no better ideas or opportunities to deploy that cash to earn an incremental return.
What these people fail to recognize however, is that a healthy cash balance can act as a critical buffer against future unknown (and, indeed, unknowable) events. When I was running my company in March – June 2020 (during the early days of the COVID-19 pandemic when global commerce effectively came to a halt), I was thrilled that myself and my Board had deliberately chosen to retain a sufficient balance of cash to ensure that company liquidity was never going to be a concern, even in the face of a major macroeconomic shock.
Though keeping cash on the balance sheet can be viewed as conservative, many companies instead view a healthy cash balance as a critical tool in allowing them to be aggressive, particularly in challenging macro environments where few other companies have the liquidity to be aggressive, and where attractive deals generally become more widely available for those who possess the resources to act upon them.
How Much Cash Should I Keep on my Balance Sheet at any Given Time?
Like most good questions in business:
- This one doesn’t have a universally applicable or unambiguously true answer; &
- The right answer for you depends on where you reside on the risk/return spectrum
In selecting what the “right” cash balance is for your company, instead of choosing an arbitrary dollar amount (be it high or low), in my experience it’s best to express the number relative to something else. Four common metrics in this regard include:
- From the Income Statement: Payroll, total fixed costs, and total operating costs
- From the Balance Sheet: Debt outstanding
A more aggressive or risk tolerant CEO may choose to retain a cash balance equal to 3-6 months of payroll on her balance sheet. A more conservative CEO may choose to retain a balance equal to 6-8 months of fixed costs, and a highly risk averse CEO may choose to keep a cash balance equal to 8-12 months of total operating costs. As usual, risk and return are inversely correlated.
I mention debt outstanding because companies with debt on their balance sheets (all else being equal) are in a higher risk position than an otherwise identical company with no debt on their balance sheet would be. As a result, in answering how much cash they should retain on their balance sheets, indebted companies must recognize that they’re starting from a higher-risk position simply by virtue of the fact that somebody else (i.e., their lender) also has a claim on the assets and cash flows generated by their business.
Relative to its importance, capital allocation seems to be a relatively under-discussed subject among CEOs and entrepreneurs, particularly among those running SMBs. Regardless of how a given business is capitalized, the CEO would be well served to constantly look at her company through the lens of an investor, because that’s effectively what she is, whether she knows it or not. Though issues of capital allocation sometimes lose the battle for CEO time and attention when competing with more common day-to-day issues, the best CEOs keep it top-of-mind at all times.