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Every company must have a strong capital allocation strategy to maximize its potential. Without it, the company may end up missing opportunities and spending money on things that won't help it grow or become more profitable. In this article, Keith Levy, Operating Partner at Sonoma Brands, shares his experience on successful and unsuccessful capital allocation strategies.
“Try to create as much value as you can. If you’re too focused on a successful exit, you will run into problems. Focus on what it takes to build a great business, and then suitors, investors, and acquirers will come along.” - Keith Levy
Keith was previously the Vice president and Chief Marketing Officer at Anheuser-Busch Inc. Their primary focus was enhancing their organic growth through these capital allocation strategies:
- The first priority was capital investments. They looked at their free cash flow primarily to invest and improve their breweries. This investment would eliminate high-cost labor with low-cost capital and create a strong ROI over a period of time by reducing investment in SG&A.
- Their second priority was to buy back shares and amplify their EPS. This is more of a tactic than actual real growth.
- The third and distant priority was making acquisitions. They did some but nothing transformation to set them up as a global company.
This capital allocation strategy is partly why they got acquired. Despite being a household name for over a hundred years with Budweiser and Bud Light, there was a lack of fiscal discipline.
They were very profitable, which allowed for some very lavish expenses. The free cash flow allocation strategy was flawed. If they focused on global M&A, it would have been more effective.
Strategy vs IRR
When it comes to capital allocation, it's essential to look at both. During Keith’s time at Mars, they looked at 3 layers when assessing acquisitions.
- Does the acquisition fit a strategic need?
- What is the IRR of the investment?
- How to create value?
When creating IRR projections, you're still making a lot of assumptions, and they don't always work out. In most cases, they are all best case scenarios. If they don't deliver, then you destroy the economics of the IRR that you promised. Finding the right balance of enthusiasm with realism, and the ability to execute on that, is crucial.
Venture capital vs recapitalization strategy
The venture capital strategy is willing to assume a lot more risk either at pre-revenue or very early stages where the business is barely off the ground. There's a massive belief that the particular investment is going to have a significant return.
When talking about a recapitalization, that could mean a business needs capital. Maybe there are existing shareholders who are tapped out or have lost their enthusiasm for the business. You can get some folks to bring in secondary capital and take out those investors.
In a venture capital strategy, the company tends to allocate cash into a startup as equity. Whereas with recapitalization strategy, there's cash to purchase shares from the current ownership, and also a cash infusion to support a growth plan.
Minority vs majority recapitalization
During a majority recapitalization, the balance of power will shift to the people that own the shares. As an entrepreneur, be smart about it, and do not borrow more money than you need.
If you do, you’ll just spend it and then find yourself beholden to the people who own the paper. It’s okay to give up a significant amount of equity if you think the pie you're going to create is significantly bigger than what you have right now.
The problem arises when you borrow a lot of money, it doesn’t deliver, and then you need to borrow more, continually giving up more of your share of ownership.