Identify Capital Needs
The first step in the capital allocation process for business owners is to identify the capital demands within the business. Beyond fundamental tax and debt service requirements, the uses of capital are often more situational and dependent on a variety of factors, including risk appetite and business life cycle. Owners with higher risk appetites and a history of successful business integration are likely to be more comfortable accelerating growth through an acquisition strategy. Owners with lower risk tolerances may favor more gradual organic growth strategies while diversifying their holdings through dividend distributions.
After establishing the capital needs to support the business strategy, business owners must consider debt obligations and near- and long-term shareholder liquidity needs. Finally, they should determine whether capital is necessary to achieve certain long-term personal goals or objectives, specifically business succession. For example, the sudden death of an owner can create a major taxable event that puts unnecessary stress on the business’s capital if a thoughtful, tax-efficient estate plan is not established ahead of time. Acquisitions, ownership transfers and stock redemptions are other key capital-intensive events that are best handled within the firm’s long-term capital allocation plan. Balancing these competing demands requires careful consideration and discipline. Equally as important as planning is retaining the flexibility to move business resources to adjust to shifting market conditions and act decisively when opportunities emerge.
Analyze Allocation Options
Business owners should evaluate the alternatives before deciding on how best to allocate capital. Many private companies rely on qualitative approaches such as “gut feel” to make capital allocation choices; however, when contemplating a project (e.g., building a new factory) or business initiative (e.g., growing the sales team), strategic imperatives should be quantitatively assessed using an appropriate technique such as ROIC, internal rate of return or net present value. Smaller firms are more apt to lean on simpler metrics such as payback periods to evaluate projects, as future project cash flows are less predictable and owners are less likely to utilize external sources of capital to fund initiatives. Regardless, these quantitative tools bring discipline to decision-making and can help the business owner make deliberate, well-informed decisions.
Execute the Allocation Plan and Evaluate the Results
Capital allocation decisions should be revisited, reviewed and refined continually as circumstances and opportunities change. Looking back at historical perceptions and actual outcomes is an honest way to weigh the success of prior decision-making. Many companies form internal committees to collaboratively decide on the best uses of capital within the business. Others rely on board members and advisors to debate capital allocation decisions on a formal biannual schedule and link the two areas of competing demands – family and business. It is important to appreciate that the allocation process is evergreen. The process itself is a positive feedback loop, as the lessons learned deploying capital in prior years will inform and improve future decisions.
Capital allocation is a key priority at Brown Brothers Harriman (BBH) and permeates all facets of our business daily. As investors, it goes hand in hand with our value investing philosophy, as we partner with investment managers and management teams who are exceptional stewards of capital. Because of our private partnership structure, BBH Partners are both owners and managers of the firm, giving careful consideration to capital allocation decisions like other private business owners.
Bringing an investor’s mindset to the business of management is as critical as operational excellence. While the details are specific to each company’s unique business strategy, capital structure, financial condition and owner needs, and there is no one-size-fits-all solution, the development of a capital allocation strategy is important for every private company. A well-defined approach to capital allocation will lead to better decisions and drive long-term value creation.
The Corporate Advisory Group (CAG) is dedicated to building and expanding relationships with clients and prospects of Brown Brothers Harriman (BBH) Private Banking through an objective long-term corporate finance dialogue. CAG operates outside of the traditional transaction-focused, success fee-based investment banking model. As a result, CAG is able to approach clients’ unique needs without bias for any particular outcome and provide advice to best help clients achieve their business and personal goals and objectives. For more information on CAG, please contact your BBH relationship manager or John Secor, Head of Corporate Advisory, at email@example.com.