At a recent meeting with longstanding family business clients, management mentioned that one of their independent directors had introduced the term “lazy capital” into the family’s vocabulary. We had never heard that term before, but it perfectly encapsulates something we see at too many family businesses: an undisciplined capital allocation process that tolerates sustained underperformance. We ran across a couple articles this week that, while written with public companies in mind, made us think about the perils of “lazy” family capital.
Capital, Culture & Communication
The first article posted by Big 4 accounting firm EY was entitled “Is Your Capital Allocation Strategy Driving or Diminishing Shareholder Returns?” In the piece, EY offered eight leading practices for allocating capital, two of which made us think about our family business clients.
Number three on EY’s list was this: “Establish a ‘cash culture’ that prizes cash flow and does not tolerate unnecessarily tying up capital.” Perhaps it is more natural for public companies to prioritize a “cash culture” than it is for family businesses. After all, family businesses have the advantage of not being on the quarterly reporting treadmill, or worrying about the day-to-day or week-to-week changes in share price. Yet, a “cash culture” need not result in unhealthy short-termism. For family businesses, a “cash culture” can help provide the foundation for long-run sustainability. The managers of a family business with a healthy “cash culture” understand that family capital does have alternative uses outside the family business, and are focused on being good stewards of the capital that the family has entrusted to them. As a result, “cash culture” family businesses are more flexible, more attuned to emerging risks and opportunities, and ultimately more accountable to the family.
Consistent and credible communication lays the groundwork for the difficult capital allocation decisions that enhance the long-run sustainability of the family business.
The seventh item on the EY list was to “Align capital allocation, strategy, and communications.” Relative to public companies, some family businesses are late to the party when it comes to sophisticated capital budgeting tools. However, despite the merits of net present value, internal rate of return and other quantitative concepts (which are many), those capital budgeting tools accentuate, rather than diminish, the importance of a clearly-articulated corporate strategy to allocating capital properly. Quantitative tools can be used (whether intentionally or not) to support proposed capital projects that do not advance the family business’s strategy. The quantitative greenlight should be viewed as a necessary, but not sufficient, condition for approving capital projects. Knowing that corporate strategy is essentially the art of saying “no” at the right times, successful family businesses require a compelling and simple answer to the “why” question: Why is the proposed project a good fit for us?
Public companies work hard to ensure that corporate strategy is effectively communicated to existing and potential shareholders. The results of failing to do so can be disastrous – if public company shareholders don’t understand or don’t believe or simply don’t know what the company’s strategy is, they can vote with their pocketbooks by selling shares. When public company investors head for the exits, the share price becomes depressed, leaving the company vulnerable to hostile takeover or vulture investors.
Since family shareholders do not have ready liquidity, does that diminish the importance of communication for family businesses? No. If family business directors fail to communicate well, family shareholders eventually become disengaged, suspicious, and far too often, litigious. Family businesses simply have too much at stake not to take communication seriously. Consistent and credible communication lays the groundwork for the difficult capital allocation decisions that enhance the long-run sustainability of the family business.
Putting the Family Business on a (Capital) Budget
A recent “Head to Head” feature in the Financial Times (subscription required) pitted two economists against each other on the topic of share buybacks. One economist, citing the baleful influence of aggressive share repurchases, argued that they should be strictly curbed, while the other praised the effectiveness of buybacks in promoting a long-run perspective on the part of company managers. The specific arguments put forth (with varying degrees of cogency) don’t need to concern us here, since they apply to public companies.
For family businesses seeking vigilance against “lazy” capital, what is the proper role of share repurchases?
But for family businesses seeking vigilance against “lazy” capital, what is the proper role of share repurchases? Most family business directors are rightly wary of wild swings in annual per share dividend payments. However, one side effect of that concern is that when financial performance is strong, undistributed capital at the family business may be inclined to put on the stretchy pants and become “lazy.” A disciplined dividend policy can actually result in an undisciplined reinvestment policy. When retained capital is plentiful, it becomes more tempting to approve marginal capital projects, or those with only a tenuous connection to the family business’s strategy. Repurchasing shares can function as the release valve that allows family business directors simultaneously to maintain a steady annual dividend and keep the family business on a prudent financial diet when it comes to capital investment.
The biggest challenges surrounding share repurchases for family businesses are getting the price right and communicating with shareholders. A price that is too low will take economic advantage of selling shareholders, while a price that is too high may cause a proverbial run on the bank. Shareholders need to be fully informed about why the repurchase is occurring, at what price, and what their options are with regard to tendering shares.
Share repurchases won’t be a good fit for every family business. For some, a periodic special dividend may fulfill the same function. But they are a key tool available to family business directors in the ongoing fight against “lazy” capital.