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All About Capital Allocation
Today: Capital allocation might be the more critical discipline when it comes to building successful businesses.
The Agenda 👇
Why capital allocation matters
How it relates to capitalism in general
Capital allocation in the current macroeconomic environment
You should read more from Michael Mauboussin
Every Successful Business Has Two Financial Loops
I’ll make this one short, since you’re likely busy preparing for tonight’s party and looking forward to the new year! Today I’ll simply point out another thread in my writings this year, that of capital allocation. The first essay covering it was Principles for Capital Allocation (April 2020):
We’ve long since entered a world where all businesses are hybrid—part software, part non-software. The whole question is the balance between the two. We can see it as a sliding scale, from Category 1 (no software) to Category 5 (pure software)...
From Category 4 upward, the network effects derived from software (demand-side economies of scale) dramatically outweigh the supply-side economies of scale (large volumes, lower unit costs). Unit economics depend on the category to which the business belongs. It then commands a specific approach to capital allocation to make the most of the company’s distinctive value chain. Again, software is all scalability (you can grow very quickly as long as there is room for it); at the other extremity, non-software is defensibility (it's difficult for a new entrant to compete with you).
This is all part of a wider reflection on capitalism and why it contributes to higher returns on invested capital. Here’s the whole series of related essays:
Capitalists Beat Merchants Everytime (November 2017)
Give Capitalism a Chance (October 2019)
Capitalism and the Future of Nation States (December 2019)
Capitalism Today: Customers as Shareholders (January 2020)
Accounting for Capitalism (November 2020)
A key point for both capitalists in general and capital allocators in particular is understanding the importance of a business having a ‘grip’ over its value chain. This was the focus of Thoughts on Value Chains, and Why You Really Need To Get a 'Grip' (June 2020):
It’s not enough to dominate one sector with increasing returns to scale. For instance, you can’t just assemble the cars without also owning and marketing the brands. And you can’t just own the rights to recorded music without also marketing artists to the public.
Back in the corporate finance realm, there were several sections of A 10-Point Checklist For Building a Great Company (September 2020) that covered capital allocation per se:
In the old world, investments were made in machines and product development, after which financing growth was all about operational expenses. In today’s world, because there’s such a thing as network effects, a new customer contributes more than cash: they also create additional value for your company that then forms a surplus to be divided between the three parties at the corporate table: customers, shareholders, and employees.
So now, because an additional customer creates value over the long term, spending money on acquisition and conversion is akin to an investment. It might not be treated as such from an accounting perspective (read this brilliant piece by Napkin Math’s Adam Keesling about this), but you, as an executive, should learn to effectively treat it as an investment nonetheless.
In two subsequent essays, I dove deeper into the relationship between the macroeconomic context and how business leaders should allocate capital. One was Why Is It Still So Hard to Raise in a Time of Cheap Capital? (October 2020):
The Family’s mission is to help entrepreneurs succeed, and so, having learned all that, I kept asking myself: Why is it still so hard for a founder to raise money? Where’s all this cheap capital I’m reading about in the FT and Fidelity’s research publications?
It turns out it’s not that easy to allocate large amounts of capital when most economic agents (from businesses to governments to individuals) have been trained to think that capital is a scarce resource.
The other, which I opened with a reminder that Michael Mauboussin was the one who inspired my interest in corporate finance, is What to Make of Low Interest Rates (December 2020):
I had some back and forth emails recently on the topic of capital allocation, triggered by the following compelling idea by Michael Mauboussin:
Fund strategies, not projects. The idea here is that capital allocation is not about assessing and approving projects, but rather assessing and approving strategies and determining the projects that support the strategies. Practitioners and academics sometimes fail to make this vital distinction. There can be value-creating projects within a failed strategy, and value-destroying projects within a solid strategy.
More recently I discussed a critical feature of every company that excels at allocating capital: they have two financial loops reinforcing each other—the ‘trading’ loop and the ‘capitalist’ loop. Have a look at Every Successful Business Has Two Financial Loops (December 2020):
It’s difficult for any company to make do with just one loop only. If a business venture is 100% within the market economy, money constantly flows in but it’s very difficult to scale up and generate increasing returns to scale. That’s typically what happens to a small business—it stays small because it focuses on mercantile trading rather than inserting the capital that would trigger increasing returns to scale.
On the other hand, if you’re 100% on the capitalist side, then you’re growing assets whose value compounds over time, with ever increasing returns on invested capital. But over the short term you don’t have free cash flow, which means you have trouble making a living. That is what happens to fund managers, which is why they negotiate with their LPs so as to be able to support themselves while the capital is working. Management fees are simply a cut of future returns paid in advance until the value of the assets under management comes to fruition.
Finally, here are other essays that provide more context for my work on capital allocation:
The Entrepreneurial Investor: An Overview (May 2020)
Can Private Equity Firms Make Money in Tech? (June 2020)
Notes on Revenue-Based Financing (July 2020)
An Important Point About Increasing Returns (September 2020)
On Jerry Neumann's “Productive Uncertainty” (Round 1) (November 2020)
On Jerry Neumann's Productive Uncertainty (Round 2) (December 2020)
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From Munich, Germany 🇩🇪