The first goal of most entrepreneurs is to build enough scale, talent, and redundancy to remove themselves from the day-to-day aspects of running their business. If they’re able to do that, they typically focus their time on three things:
The first two typically align well with the skills they have from running their business. Capital allocation is where most leaders struggle, for one key reason: They only think about capital allocation within their own business.
When it comes to capital allocation, most entrepreneurs ask themselves some version of these questions:
These are valid questions to be asking, but they’re far too simple. Many thoughtful entrepreneurs trick themselves into thinking they’re thoughtful by calculating the expected return on investment (ROI) from their capital investments across the business. That granular approach is essential, but as they dive further into the weeds, they get even further from understanding the bigger picture. Instead, they need to be thinking about the following:
How does the internal rate of return from capital investments I make in my business compare with capital investments I can make outside of my business?
Whether you’re the sole owner of your business or have partners, you should be thinking much more broadly when it comes to where to invest your free cash flow. In the simplest form, everyone should be asking themselves this question:
Will my risk adjusted IRR of new capital projects be greater than other vanilla investment options outside of the business? If you believe you can compound 7-10% in the stock market with full liquidity, will that be a better investment than investing in your own business?
Alternatively, if you’re highly focused on building your business’ enterprise value ahead of a potential sale, think about this:
Will my risk adjusted IRR of new capital projects PLUS the expected growth in enterprise value be greater than other vanilla investment options?
Most entrepreneurs reading this will believe that their internal capital projects will earn more than the average stock market return. They could be correct. But this isn’t always an easy decision if you have access to alternative investment opportunities such as private equity, venture capital, etc. All these options suffer from the same illiquidity that you have in your business, but they may offer increased risk-adjusted returns.
If you’re investing in a fund structure, wouldn’t you think it would be far too risky for the general partner to invest the entire fund in one business or one real estate project?
What is hard to calculate is the value of diversification for business owners. For example, if you own a high-end construction business, you’re heavily exposed to economic cycles. Continuing to invest in your business may offer a high potential return, but would you take a lower return if it had a negative correlation with the performance of your core business?
This is the mistake that most business owners make. They become laser focused on their business. It’s their baby after all. Don’t make that mistake.
Almost all business owners stress the importance of control. They want to control their investments because they believe it will result in better performance. Without debating the accuracy of this statement, I understand how it can be challenging to give up control when you’re so used to building and growing a business.
Once a business is free cash flow positive and generating significant wealth for the owners, if an owner recognizes the importance of diversification, but still wants control, it’s time to start thinking about a hold-co structure. The concept of a holding company isn’t a revolutionary idea. By definition, a holding company is nothing more than a business with no other purpose than holding and managing ownership in other companies. Berkshire Hathaway is one of the more famous examples of a holding company. Berkshire exists for the sole purpose of Warren and Charlie acquiring ownership stakes in other companies.
If you’ve been able to grow a business and successfully create scale and processes, you can likely transfer that skill to another business that you either build or acquire. This type of structure allows you to diversify your overall revenue stream and reduce your overall risk.
The real question you should be asking is, do I buy, or do I build? I’ll share my thoughts on that soon.