“Understanding intrinsic value is as important for managers as it is for investors. When managers are making capital allocation decisions … it's vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. ... Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value.” – Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1994.

Berkshire Hathaway Chairman Warren Buffett is widely regarded as one of the most successful investors in history; his management track record is arguably just as singular. A hallmark of Buffett’s management philosophy is his unusual attention to capital allocation. He advocates that capital allocation is equally, if not more, important than operating prowess in driving long-term shareholder value.

Studies show that companies that continually evaluate the performance of business units, acquire and divest assets, and adjust resource allocations based on relative market opportunities outperform those that do not. The development of a capital allocation framework is a strong catalyst for value creation. While capital allocation is generally perceived to be more relevant for public companies, it is just as important for private companies.

Capital allocation framework

Capital allocation decisions are vital in determining a company’s future and, as such, are among management’s most important responsibilities. Managers have three basic choices for deploying capital:

• Reinvesting in the existing business (underwriting capital expenditures, funding research and development, or adding to the sales team)
• Acquiring another company
• Returning cash to claimholders (issuing dividends, redeeming shares, and repaying debt)

Choosing between these options requires discipline and careful consideration. An unsound capital investment decision can hinder value creation in a business by depriving more deserving initiatives of scarce resources.

Capital allocation’s importance becomes more apparent over a business’s life cycle. In the early stages, decisions about allocating capital are relatively simple – most of the cash flows are poured back into the growing company, and there is typically limited cash to deploy. Eventually, a business matures, meaningful organic growth opportunities tend to diminish, and cash is accumulated.

Whether capital is generated through operations or raised through the issuance of debt or equity, the deployment of capital drives the long-term value creation opportunity for the business.

Why capital allocation matters for a private company

While capital allocation is a central issue for all firms, it deserves particular attention for private businesses for which capital is scarce and less readily accessible compared with publicly listed companies. Capital allocation decisions are often viewed too simplistically by business owners who frequently take a reactive approach, such as defaulting to decisions made at year-end to reduce taxes. The year-end purchase of a new piece of equipment may reduce near-term taxes, but may also underfund other opportunities to accelerate longer-term growth and larger future distributions to shareholders. Although it is important to operate in a tax-efficient manner, tax planning should inform, not determine, long-term business strategy.

In addition to having limited access to capital, an owner of a private company is also uniquely challenged to balance the needs of the business with personal estate planning, particularly as private company stock often represents the largest asset on his or her personal balance sheet. Unforeseen personal events can present additional demands for capital that affect the business and make the capital allocation calculus more difficult.

This can be further complicated particularly in multigenerational businesses with passive shareholders and/or institutional investors that have conflicting holding periods and priorities for liquidity vs. reinvesting in the business. Developing a disciplined approach to decision-making will help owners navigate the capital allocation process and drive long-term value in their business.

A private company approach to capital allocation

The manner in which companies allocate capital is remarkably varied. Some companies make capital decisions based on relative size, performance, or growth potential of the business units. Others simply apportion the same resources provided in the prior year. Regardless of the approach, capital allocation decisions should be guided by an active and objective approach to identify, analyze, execute, and evaluate the firm’s options for managing its capital.

Well-run public companies develop core principles to steer their capital allocation decisions. For instance, Microsoft establishes specific capital allocation goals that encompass growth funding, mergers and acquisitions, dividends, and buybacks. Microsoft also tracks various metrics, such as revenue growth, operating profit margins, and return on invested capital (ROIC) to assess the success of its capital allocation strategy and inform future decisions. For Microsoft and other leading companies, a clearly defined framework and set of objectives is the roadmap for effective capital management.

For private companies, the principles developed to guide capital allocation decisions should support the business’s needs and strategies and take into consideration shareholder liquidity timeframes and objectives. The ultimate outcome of capital allocation choices is rarely immediate or obvious, thus requiring decision-makers to adopt a long-term view when developing goals and assessing success. In that sense, most private companies are well suited to the capital allocation process given their orientation toward building a sustainable business that can be passed on and harvested across subsequent generations.

Similar to the multiyear business planning process, it is important to create a multiyear capital allocation plan that is guided by long-term owner goals and business objectives while also maintaining sufficient flexibility to adjust to changing market conditions and act decisively when opportunities arise.

A robust process will enable decision-makers to identify competing capital needs, analyze the various opportunities, execute the strategy, and evaluate the effectiveness of the decisions made. 

Conclusion

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.