Despite our best efforts, having four kids in the house means that we are a net candy importer over the Halloween weekend. Staring at the piles of candy in our house this morning brought to mind several recent conversations we’ve had with clients and prospects. The topic of those conversations was “lazy” capital.

What Do We Mean by Lazy Capital?

We were introduced to this term a few years ago, and it rather aptly describes a common situation in family businesses: capital on the balance sheet that is not generating a fair return for family shareholders.

Where Does Lazy Capital Come From?

Unlike leftover Halloween candy, lazy capital tends to accumulate slowly. I’ve not seen too many family businesses that have intentionally built bloated balance sheets. Perhaps ironically, the threat of lazy capital accumulating on the balance sheet is greatest for successful companies. How do successful companies wind up with excess capital?

The following five broad headings capture most of the reasons.

1. Reluctance to Invest in New Business Lines

Like all companies, a family business has a natural lifecycle. At some point, the original business of the family will mature, with slow (or no) sales growth and more limited reinvestment needs. At this point, the family business directors should be deliberate about either (a) adopting a “harvest” mindset or (b) identifying new fields to “plant.” Families that are unwilling to take on the risk of “planting” a new crop of investments are much more likely to see lazy capital accumulate.

2. Reluctance to Pay Distributions

Some family businesses appear to avoid paying significant distributions out of earnings on principle: owning shares in the family business should not provide one with disposable income. This “principle” is generally animated by a belief that the family shareholders cannot be trusted with financial resources. Granted, there is no shortage of individual family shareholders whose stories amply validate this fear. However well-intentioned, we suspect that a reluctance to pay distributions often has serious unintended negative consequences for the family, one of which is the accumulation of lazy capital on the family business balance sheet.

3. Reluctance to Divest Unproductive Assets

Family businesses occasionally have sentimental attachment to lines of business, facilities, and other assets that have outlived their usefulness to the family business. If Division X is consistently generating a 2% return on invested capital with no real prospects for improvement, it should not be considered untouchable, even if it was the apple of Grandpa’s eye thirty years ago. Family business managers and directors are asset allocators, and a refusal to evaluate business assets and segments with a cold eye will lead to a bloated balance sheet stuffed with operating assets that either do not earn an adequate return or no longer fit the strategy of the family business.

4. Reluctance to Do Things Differently

Without intentional attention and monitoring, the business practices that worked well a decade ago may not be driving optimal use of capital today. Working capital can be an overlooked hiding place for lazy capital. Active management of accounts receivable, inventory, and payables is critical to ensuring that the family is earning an appropriate return on its capital.

5. Reluctance to Acknowledge Available Borrowing Capacity

Many family businesses are debt averse. Capital structure is a function of, among other things, family risk tolerance. Yet, there is a difference between a family business preferring to operate without debt and one maintaining a cash balance sufficient to meet every potential contingency facing the business. The prudent move for debt-averse families is to maintain and update credit facilities that will allow the business to handle sudden cash needs that may arise without carrying unwieldy cash balances which weigh down investor returns. Even families that prefer not to use debt should acknowledge their ability to issue debt in the future if needed. That borrowing capacity should not be ignored in risk management discussions. Ignoring the available borrowing capacity of the family business leads to an exaggerated sense of how much liquidity the company needs to maintain on the balance sheet.

What Are Some Consequences of Lazy Capital?

Unlike leftover Halloween candy, an accumulation of lazy capital is unlikely to lead to tooth decay or increased risk of diabetes. However, there are some negative consequences of which family business directors should be aware.

Diminished Returns

This one is just math – if a significant portion of your family business capital is allocated to low-returning assets, the overall return earned by the family will be pulled down. In today’s low-rate environment, the return on cash is functionally zero. As a result, allocating 10% of invested capital to cash means taking a 10% haircut to what would otherwise be ROIC. We’ve written about ROIC in a prior post because for most family businesses it is the best comprehensive measure of performance. Whatever form it takes, lazy capital puts pressure on ROIC.

Lazy Management

We are all more aware of how viruses spread these days, and laziness is infectious. The presence of lazy capital on the family business balance sheet can take away a healthy “edge” in how the business is managed. It is not in anyone’s best interest to fabricate some artificial sense of crisis. However, we suspect most businesses operate best with what one of our high school coaches was fond of referring to as a “sense of urgency.” An accumulation of lazy capital can blunt the productive sense of urgency and breed unintended negative consequences throughout the business.

Disgruntled Shareholders

Lazy capital flourishes in an environment of limited, or poor, shareholder communication. And poor communication inevitably leads to mistrust and conflict. Positive shareholder engagement is much easier to maintain when family shareholders are confident that their capital is being put to good use.

How to Get Rid of Lazy Capital?

It’s easy enough to foist leftover Halloween candy on unsuspecting co-workers. Disposing of lazy capital is less straightforward, but the two primary strategies are to (1) return the lazy capital to shareholders so they can put it to work themselves, or (2) find more productive uses for the lazy capital within the family business.

Finding the right strategy for dealing with lazy capital in your family business is a complex process that needs to consider the attributes of the business, your industry, and your family. Give one of our professionals a call today to review your situation in confidence and see how we can help.