In Econ 101 we learn that businesses exchange the revenue earned from selling goods and services to buy land, labor, and capital (by selling equity and/or borrowing). The amount businesses spend in the “market for resources” is called the cost of production. Translation: In business, you have to spend money to make money.
In this article, we discuss how businesses should deploy capital. Successful businesses deploy capital to build and sell products that customers want to buy, at a price that covers the costs of production, including a fair return to shareholders and lenders.
In general, a successful business always can raise more capital to help it expand because the providers of capital see that the business has a successful formula.
Businesses that fail also deploy capital, but not successfully. They burn through whatever funds they raise in an attempt to build and sell a product or service, but they either fail to launch before running out of money or cannot find enough customers who want to pay a high enough price to cover their costs of production. In a way, that summarizes why businesses succeed or fail, so we could just stop here.
But of course, there is more to deploying capital wisely to help drive business success, so let’s dig in.
Capital deployment at different stages
In the early stages of a business, deploying capital is about building a product and then generating sales. In later stages, spending becomes more about how to increase EBITDA while still growing and innovating.
In the very earliest stage, the sole focus in deploying capital should be to develop a viable product. Note that “product” refers to anything customers are willing to pay for, which could be tangible objects (gadgets, clothing, medical devices, and so on), as well as software or some type of service (hotels, food delivery, etc.).
Developing a product requires engineering (which could be software engineering), design work, and some project management, with the goal of producing a prototype. This indicates how the company’s available capital should be deployed at this stage – the focus should be on creating a Minimum Viable Product (MVP). Building up a sales force or adding a lot of nice-to-have features would not be a good use of capital at this stage.
The point of the MVP, which could be anything — a revolutionary clean energy technology, a new retail concept, whatever — is to test the market and determine what changes must be made (what features must be added) to generate ongoing sales.
There is no point in spending precious capital on salespeople at this stage when you have nothing to sell. The CEO can be in charge of showing the MVP to potential buyers to get feedback.
A Tale of Two Start-Ups
A few years ago, we worked with two companies that were at the early start-up stage. Both were investing in engineering to develop their products, but one was spending a substantial amount of its capital on sales and marketing.
Early on, the sales-focused company generated more revenue relative to the amount of money it had raised than the engineering-focused business. But the company that used the majority of its capital to develop its product to a point where it could attract customers was far more successful in the longer run.
Remember, the “M” in MVP stands for the minimum. To support a successful business a product will need more than what is in the prototype. So, just because you have an MVP that shows your basic concept to potential customers does not mean you now use most of your capital to try to generate sales with that prototype.
The business should shift to sales and marketing focus only after gathering some decent feedback on the MVP. Ultimately, sales and marketing will likely become the largest expense category, but in the earliest stage of the business that is not the best way to deploy capital.
Growth stage capital deployment
When your company has developed a viable product and has been generating sales, you are probably able to raise capital more easily. Here, we offer some insights about how to think about deploying that capital wisely, which is largely a function of whether your company manufactures a product, delivers a service, or develops software.
Before we go into the details, we again refer to classic, academic theory – in this case, the concept of net present value. Remember that if a project or undertaking has a positive NPV, it is expected to generate more than enough revenue to cover all expenses, including the cost of capital (which is the denominator in the NPV calculation). This gets back to the idea that capital has to be deployed carefully – spending too much in the wrong categories will not create value. Now we look at what that likely means for different types of businesses.
Manufacturing businesses typically need to spend to maintain their plants and equipment. Inventory and accounts receivable also require capital. These businesses, both small and large, can easily end up with too much capital tied up in inventory.
The post-COVID “inventory hangover” is a good example: When much of the service economy shut down and working from home became the norm, consumers went on a buying spree. With supply chains snarled from end-to-end retailers did not want to risk having bare shelves so they increased factory orders, to be “safe”. Two years later, warehouses are overstuffed, and retailers are canceling orders and refusing shipments.
Of course, this can happen even without a pandemic. In fact, anticipating demand is probably the most difficult thing a manufacturing business has to do.
Using up capital by overestimating demand can be devastating – stocking a warehouse with goods that go out of style or become obsolete before they can be sold, or buying more production equipment and leasing more factory space that goes unused burns money (selling excess inventory at discount cement the loss).
On the other hand, if your inventory is too thin to satisfy buyers’ needs they will go to competitors and may never come back. Investing in improved data gathering and data analysis to help make better demand forecasts may be worthwhile.
In a Service business, personnel is the equivalent of inventory. People represent the largest use of capital, followed by the cost of leasing space and/or equipment to deliver your service. If you have too many people on the payroll you are wasting money; if you have too few, customer service suffers, which creates disgruntled customers who bad-mouth your business and never come back.
In a tight labor market, paying more employees than you need may be a smart use of capital because replacing them may be even more costly.
Still, businesses should carefully monitor staffing needs against changing labor market conditions. Relying on contractors to adjust your workforce is another option but there are drawbacks, as contractors may not have the same focus, loyalty, and commitment as employees.
For Software businesses, personnel is also the largest use of capital, but with a different perspective than a service business. A software business cannot succeed without attracting and retaining quality programmers, so that is where most of its capital should be spent.
Ultimately, the goal of deploying capital wisely is to increase the value of a business. At the venture capital stage, that means focusing on increasing annual recurring revenue or becoming a Rule of 40 company (Sales Growth % + EBITDA Margin = 40+).
For more mature businesses seeking growth funding or a buyout, the focus should be on deploying capital in a way that grows revenues and EBITDA efficiently. As we noted at the beginning, a business has to spend money to make money. Spending is easy – spending wisely is harder, but it’s the right goal.
We will walk you through how to approach the analysis, based on your specific situation.
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