“What do you mean we can’t pay dividends this year?” Elisa was incredulous. The board of the watch company she and her husband Mark had founded had just reviewed projected end-of-year performance. Usually this meeting was a celebration of another incremental step forward, with moderate growth, no debt, and significant dividends, which Elisa and Mark used to support their comfortable lifestyle and charitable donations. This year, however, revenue growth was way up, but profits were down, and the covenants on the debt taken out by the company to achieve that growth did not allow for any dividends. It was the first time that Elisa had felt out of control of the company she had co-founded. (Throughout this article, names and identifying details have been changed to protect confidentiality.)
How could the founders and sole owners of a company find themselves surprised by its inability to pay them annual dividends? Elisa and Mark had done many things right in building their business, including eventually appointing an independent board and an outside CEO to help the company reach the next level. But they made one crucial mistake. They failed to clearly and concretely articulate their “owner strategy,” meaning the tangible outcomes that they wanted to achieve – and avoid – as owners.
For widely-held public companies, the owner strategy is simple. They are owned primarily by institutions (like index funds) or investors who have no personal tie to the business. These owners expect the company to maximize the growth in value of their shares, usually measured by hitting quarterly earnings targets. Indeed, most of what is taught in business schools and described in management literature is based on the assumption that companies exist to maximize shareholder value. But “that assumption ignores an equally obvious truth,” Bo Burlingham points out in Small Giants: “What’s in the interest of the shareholders depends on who the shareholders are.”
For the vast majority of businesses in the world, controlling ownership is in the hands of people with a tie to the company, rather than outside investors. That includes companies owned by founders, families, foundations, partnerships, and employees. Family businesses alone account for approximately 70% of companies in the US, 79% in Germany, 85% in France, and over 90% in Asia, India, Latin America, and the Middle East. When these businesses are privately held, they provide owners the most freedom to define how they will measure success. They can choose to pursue certain outcomes and avoid others, even if they do not maximize the economic value of their business.
We have found that very few of these owners would describe their sole objective as maximizing shareholder value–and for many, it is not their primary objective. Yet, they are often not clear about what they do want, which can create missed opportunities for growth, a loss of talent due to frustration over the direction of the business, or a loss of control by the owners as management fills the void in with their own priorities. A clear owner strategy is critical to keeping a business on course.
Passion Project or Growth Machine?
In the case of Elisa and Mark’s watch business, their mistake was in not articulating their owner strategy to themselves and then sharing it with the rest of the company. They had started their watch business several decades ago as a passion project. Elisa had been trained as an engineer and was fascinated by how to improve the functionality of the product. Mark helped come up with sleek, new designs and had eventually left his job to help her launch the company. Together, they created one of the industry’s most distinctive brands, with revenue approaching a billion dollars. But growing the business had never been a priority for them. As long as it maintained the culture of innovation and allowed them to enjoy the fruits of their labors, Elisa and Mark were happy.
As the company grew to a size that exceeded their ability to manage it, they decided to hire an outside CEO with a strong track record in their industry to take over day-to-day operations. The CEO saw an opportunity to aggressively grow the business, and invested heavily in international expansion and the IT systems required to support it. He also came up with less expensive, and lower quality, versions of the core products in order to broaden the company’s appeal. Although there were promising signs from these investments, the lack of profit growth–and the missed dividend–led the founders to realize that the CEO’s vision was out of sync with their own priorities.
So the founders opted to fire the outsider CEO and elevate an insider to the role instead. While the new CEO lacked the outsider’s credentials, they knew that he would ensure a return to a prioritization of culture and creativity over hockey-stick growth. They created a clear owner strategy to guide all of the company’s major decisions – and achieve their own definition of success. To avoid a repeat experience, they spelled out their owner strategy to the company and worked with the board to align the new CEO’s compensation incentives with it.
Define Your Owner Strategy
An owner strategy generates alignment among owners, board members, executives, and employees, which, in turn, improves both performance and satisfaction. Think of it this way: if owners are clear about how they want to keep score, board members and management teams will know how to win. That clarity also allows companies to define success on their own terms, rather than someone else’s. And isn’t that the point of owning a business, or working for one?
Defining an owner strategy requires asking two basic questions:
- What are your goals: growth, liquidity, or control?
There are three broad goals that owners can seek. They can aim for growth, meaning to maximize the financial value of the business. They may pursue growth to build long-term wealth, broaden their impact on society, or for the psychic rewards that accompany getting bigger. They can also seek liquidity, which is to generate cash flow for the owners to use outside of the business. Liquidity can be useful to pay for lifestyles, fund philanthropic efforts, or allow owners to have more independence by diversifying their assets. Lastly, they can want control by keeping decision-making authority within the ownership group. Some owners want control over their own destiny and don’t want to give up their autonomy to anyone else. Others value control as a way to run the business in a way that preserves what they value, such as a distinctive corporate culture, or having a company that lasts for generations.
Most successful businesses face a trade-off between the pace of growth, how much liquidity the owners take out of the company, and how much control the business retains over its decisions. A company could pursue only one of these goals, or some mix of the three. But for most companies this is a “pick two problem,” meaning they can focus on two at the expense of the third.
Growth-control (GC) companies are focused on getting bigger while maintaining control over decisions. They grow primarily through their retained earnings, paying low (or no) dividends to the owners. They also have low (or no) external equity or debt, since answering either to outside investors or borrowers requires surrendering a level of autonomy. When outside equity is taken on, it is often done on a limited basis or through dual-class shares that ensure the core owners maintain control (as in Google/Alphabet and Facebook). The avoidance of debt is often a surprise to those used to looking at widely-held public companies or private equity firms, who seek to maximize returns through leverage. For private companies, debt can be useful, but is usually recognized to come at the cost of control. Closely-held public companies will often take a similar view. In its Owner’s Manual, Warren Buffett says that Berkshire Hathaway will “use debt sparingly,” and will “reject interesting opportunities rather than over-leverage our balance sheet.”
Growth-liquidity (GL) companies are also growing rapidly, but are paying out money to the owners and using other people’s money (equity and/or debt) to keep the engine going, giving up some control as a result. When companies go public, they are adopting this strategy. Private companies can use it too. We worked with one business that had a lot of growth potential, but the owners were concerned about the long-term threat for disruption in their industry. So they sold a stake in their business to a strategic investor and used part of the proceeds to diversify into other areas.
Liquidity-control (LC) companies are not concerned with how rapidly they grow, but instead want to produce significant liquidity for the owners while allowing them to maintain control over decision-making. Elisa and Mark fit this profile as owners of their watch business.
These are broad types, and companies can find a space in between. But, as they move from one part of the triangle to another, they are making trade-offs among the three main goals.
Each of these core types brings its own advantages and risks to be managed. And we know of highly successful companies that follow each path. The key is for the owners of a company to be aligned on what goals they want to pursue, recognizing that there are trade-offs among them. It is also important to revisit these trade-offs as things change, either external factors like the economy and industry consolidation, or internal factors like a shift in ownership or senior management. What worked brilliantly in one environment can be a disaster in another.
We have found that aligning on the priorities of the company is extremely helpful. But to make it real, these broad goals have to be translated into specific ways of measuring performance. And that leads to the second question:
- What are your “guardrails” for the business?
Guardrails are boundary conditions that the owners want to put on the company’s actions based on their goals. They define what is in and out of bounds.
Guardrails can be financial or non-financial. On the financial side, they should align with the mix of growth, liquidity, and control that the owners want to prioritize:
- Growth in value metrics (e.g., return on invested capital or total shareholder return) show owners how financial performance compares to peer companies and/or to other investment opportunities
- Liquidity generation metrics (e.g., dividend payout ratio) inform owners if the enterprise is producing the expected amount of cash to meet the owners objectives outside of the business
- Resilience of control metrics (e.g., debt-to- EBITDA) help owners understand and manage significant risks to the enterprise that could threaten their control of it
In our experience, owners should hone in on a small number of financial metrics (usually four to six) that can define whether or not the company is successful based on what matters to them. Doing so balances providing clear guidance to the company’s leadership with leaving them ample opportunity to figure out the best business strategy.
Many owners are willing to sacrifice some level of financial performance to achieve other objectives. Oftentimes these objectives are not stated explicitly, but it is essential to define their non-financial guardrails. In our experience, they typically fall into four main categories:
- Leadership. Is it important for the company to be led by its owners, even if they are not objectively the most qualified? We worked with one family business that believed strongly that only a family member should run the company, even if it meant that it would grow less quickly.
- Sectors/geographies. Are there particular areas that the owners wish to avoid investing in, or that they want to preserve, even though they are unprofitable? Some companies will hold onto an under-performing asset because it has non-financial value to the owners, as a source of historical pride or importance to the community.
- Harmony. Are there any decisions that will be made or avoided to preserve relationships among the owners? Some companies will keep a division or office open despite its poor financial performance because it is led by an owner and closing it will have a negative impact on the broader harmony of the group.
- Business practices. To what extent are the owners willing to reduce financial performance in order to align business practices with their values (social, religious, environmental etc.)? We know one company that decided they would not supply the cigarette industry because it did not align with the owners’ values, even though it would have highly lucrative. Others pay higher than market wages or commit themselves to environmental sustainability standards that exceed industry expectations.
There are no right or wrong answers in defining guardrails. The key is to create alignment among the owners on specific metrics and targets that measure success and inform major decisions.
Create Your Owner Strategy Statement
In order to codify their alignment, the owners of a company should draft an Owner Strategy Statement, which not only articulates their goals and guardrails, but the rationale behind them.
The statement should be as specific as possible. The acid test is: does it help the company make decisions that require tradeoffs? For example, one business we know set a 15% return on invested capital (ROIC) target for its retained earnings. During the time that the market was expanding, they reinvested almost all of the profits back into the business. As the market matured, they began to reduce investment and increase distributions to shareholders.
A good Owner Strategy Statement should be the basis of a dialogue between the owners and board/management, as there are times when an owner strategy may require adjustment to fit with business realities. It also should be a living document, revisited whenever there are meaningful changes to the internal or external environment. Lastly, it should be translated into a dashboard that identifies the metrics and targets the owners can use to measure success, which they should review on a regular basis.
Owning a company creates an opportunity to, within reason, choose your ownership adventure. Elisa and Mark figured this out while there was still time to make a change. Clearly defining success puts you in the position to create a company that accomplishes what matters most to you.
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