In the past, I have written about the cost of capital – both
how to measure it
and the importance of
earning more than its cost
.
Today, we look at a related problem: Taking too much money out of the business (AKA, there is not enough capital) and what to do if you are.
What are the consequences of taking too much money out?
There are several, including underinvestment in the business, be it measured by CAPEX, (machines equipment, etc.) or operating expense (product development, R&D, marketing, etc.); too much leverage; and poor liquidity. Each of these can lead to a lack of marketplace competitiveness, slower (or zero) growth and overall stagnation, or, worst of all, decline.
So how do you know if you are taking out too much money?
When you can’t properly fund the business with internal cash flow and/or appropriately priced new capital including equity, you are. When you are no longer competitive and struggling financially, you probably have been.
Getting to the Root Cause
First, let’s review the various ways in which money leaves a business, whether going to its owners or other controlling interests.
Dividends to pay taxes in pass-through entities.
While a creature of pass-through entities, particularly S-Corps, taxes are often overlooked by business operators in this situation. As a result, they don’t earn their true after-tax cost of capital and therefore don’t have funds to invest.
Dividends to distribute profits to owners.
This is the standard way to take money out of a business. But when
too much
is distributed, there is not enough to reinvest. This can happen in public companies that want to prop up the share price with high dividends. It happens with private owners because they just want the money.
Salaries that are above market price.
This is also a standard way to take out money, but it proves very costly on an after tax basis. Smaller companies in particular often prefer this method because most bank loans (especially small loans to small businesses) limit dividends to owners. A variation of this tactic involves paying market salaries to underperforming / underqualified employees who are relatives or otherwise tied to ownership. (Note that properly defining “market salary” requires investigation and analysis.)
Management fees paid to private equity owners.
Typically, these fees add to the income of the management firm and often don’t flow directly to the owners or limited partners.
Internal reallocation of investment or harvesting of businesses, product lines and so forth.
This can happen when you are doing things right and have more rewarding opportunities than old product lines, etc.
Rent or other above market payments to related entities.
Here in Boston, I see many businesses that have survived, at least for a while, because the business owners also own the underlying real estate — real estate that has gone up a lot in value. First, the business owners don’t charge market rents to their operating business. Next, they use the real estate as collateral to borrow and fund their struggling business. Eventually, they can lose it all.
In larger, more complex companies, such above market payments often take the form of franchise fees for company-owned stores in markets when no one will take the franchise and pay the fee.
In the worst example I saw,
one of a recycling business’s two owners had to personally replace a large bank loan because the company defaulted
, and he had personally guaranteed the loan. He was irked and wanted to screw his partner who had duped him into buying the business, along with (yes this is really true) 20,000 acres of swampland in Florida. So, the irked investor charged an above market rate on the replacement loan as a means of “taking” money from his crooked partner.
Yes, he did succeed in taking money out of the business. But he took so much out that the business couldn’t properly repair and replace its equipment. Management’s solution was to hire more people, losing cost competitiveness in the process. In the end, the business shut down, the owner/lender had to put significant money in to clear out the recycled materials, and all he got back was the value of the underlying, rat-invested real estate!
In general, when you underinvest in your business by taking too much out, business value is not maximized and eventually it declines.
In a worst case scenario (as in the recycling company above), the business is liquidated, often with
no return
of capital.
Three tips to avoid these problems…
#1. Measure the business accurately.
You need to know where the money is going and not going, and you need to make sure you are accurately measuring its profitability. Common problems are depreciation that is too low, poor product costing, and not tracking profitability at a meaningfully executable level (i.e., profitability and investment by product, customer, channel and so forth). Above market rate compensation to related entities can provide similar distortions, as can allocations of corporate overhead.
#2. Don’t let your lifestyle drive your decisions.
This is true for both direct business owners and private equity funds that “need” a certain level of management fees to help cover their own expenses, and that use this to determine how much they take out of the business.
#3. Adjust accordingly.
When your business’s profitability declines, there is less to take out of the business, so make changes as needed.
And a few more to cure them…
Stop doing what you’ve been doing.
This may seem obvious, but at some point, stopping is not easy. Commitments both internal and external to the business may have been made, whether family-related, personal loans, private equity funds, salaries, rent and so forth. These are hard to address and beyond the scope of this newsletter.
Consider other, less obvious options.
With an underinvested business, you can monetize the business by selling it, hopefully as an ongoing business if not as a collection of assets. Sometimes this might just be a product line.
Another option for manufacturers is to outsource some of the production to someone who has invested in that aspect of your business. Licensing and franchising are possibilities as well.
And there is always reinvesting in the business. Often, when things are too far gone, that means outside equity and, perhaps, giving up control.
In the end, and whatever the underlying causes of the problem, when you take too much out of a business, it will begin to decline and eventually fail.
