Browsing through the archives of the Harvard Business Review, we recently discovered an article from 2013 that we had previously missed. In “Deciding How to Decide,” authors Hugh Courtney, Dan Lovallo, and Carmina Clarke advocate using a broader set of tools to make difficult capital budgeting decisions. While the entire article is well worth reading, we were especially struck by how the authors categorized the different types of capital budgeting decisions facing corporate managers.
The authors identify five different types of capital budgeting decisions, distinguishable based on how familiar the decision is and how predictable the outcomes are.
- The easiest decisions are those that are familiar and have predictable outcomes. Because the company has a long track record of making similar decisions, there is a good understanding of what ingredients contribute to a successful outcome. In other words, the company has developed a reliable model for making the decision. Furthermore, the inputs to the model can be specified with confidence, resulting in a high degree of certainty as to the outcome. According to the authors, a domestic site selection decision by McDonald’s illustrates this type of problem.
- At the other end of the spectrum are novel decisions for which the company has little or no basis for predicting future outcomes. The company has no history from which to construct a good model, which is perhaps beside the point, since there are no reliable model inputs to be found anyway. The example cited by the authors for this type of decision is deciding how McDonald’s should respond to potential backlash over the fast-food industry’s role in obesity. There is no precedent action that managers can readily draw on to formulate a model, and it is nearly impossible to predict how consumers and society will respond to various actions.
The authors then proceed to identify which capital budgeting tools are most appropriate for which situations. Their comments and suggestions are insightful and worthy of consideration by family business directors. For additional perspective on capital budgeting techniques, you can download our whitepaper “Capital Budgeting in 30 Minutes” here.
… the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide.
Yet, we walked away from reading the article with a nagging sense that perhaps the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide. In other words, what types of capital projects should be going into your capital budgeting funnel? For example, before deciding whether to lease or build a new distribution facility, family business directors must first – whether explicitly or implicitly – decide that enhancing distribution is a more appropriate use of family capital than acquiring a competitor, or investing in research & development, or securing supply, or any of a host of other potential decisions having varying degrees of difficulty.
It is at this level of “meta” capital budgeting that we suspect family business directors could benefit from the decision classification scheme outlined by the authors of the HBR article. The “easy” capital budgeting decisions entail less risk, but also promise less return. Multi-generational business transformation arises from making “hard” capital budgeting decisions. What is the appropriate mix of “easy” and “hard” capital budgeting decisions for your family business? Net present value, internal rate of return, and the other traditional capital budgeting tools are not really equipped to answer this question.
We suspect that deciding “what” to decide is yet another manifestation of what your family business “means” to your family.
In our experience, there are four basic “meanings” a family business can have for a family. Knowing what your family business “means” maybe the best path toward deciding “what” to decide.
- For some families, the business exists to drive economic growth for future generations. With this forward-looking perspective usually comes a desire for higher absolute returns and a willingness to accept more risk. For these families, the ideal mix of capital budgeting decisions is likely tilted more toward the types of transformational capital budgeting decisions having low degrees of familiarity and predictability.
- Other family businesses serve as a mechanism by which to preserve the family’s capital. A prominent concern for these families is that all their economic eggs are in a single basket, so they want to build a stout fence around that basket. As a result, they will be best served by focusing on capital budgeting decisions having a high degree of familiarity and predictability.
- In contrast, other families respond to the “single basket” problem by seeking to find more baskets. The focus for these families is maximizing the harvest from the family business to enable family shareholders to store some eggs in different, uncorrelated, baskets. These families may be more willing to accept risk once an acceptable number of other baskets have been filled. Making a large volume of “easy” capital budgeting decisions that serve only to increase the size of the existing basket is not a suitable meta-capital budgeting strategy for these families.
- Finally, some families view the business principally as a source of lifestyle. The primary concern for these families is maintaining the current level of real, per capita distributions. Depending on the biological growth of the family, doing so is likely to require making some capital budgeting decisions that are either less familiar or have less predictable outcomes.
How are you and your fellow directors deciding what to decide? Is there consensus around the economic meaning of your family business to your family? Gaining consensus around the meaning of your family business can be a crucial first step to making all the strategic finance decisions you make line up with one another.