The Hidden Danger of Hoarding Capital
They called the talk "The Capitalist's Dilemma" for a reason. Not for the first time, Clayton Christensen, the decorated Harvard Business School professor and expert on innovation, was deeply critical of a key aspect of American capitalism: The tendency of public companies to be more interested in "adorning their balance sheets" than they are in pursuing groundbreaking innovations.
The talk occurred on the 8th floor of Steelcase's offices in Boston's so-called Innovation District. In front of a live audience of about 50 people, and a webinar audience of about 2,000 viewers, Christensen spoke with Harvard Business Review editor Adi Ignatius about theories he's previously presented in New York Times editorials and longer HBR essays.
Those theories center on this question: Why are public companies hoarding capital in an era when capital is plentiful?
"The cost of capital is relatively low--why are they not willing to invest?" asked Christensen. There are, of course, plenty of answers. Those answers can help you manage your own company's cash stash, even if--as a small business owner--you're still years away from having an abundance of capital to worry about.
All the Wrong Metrics
One reason for the hoarding is the need for public companies to burnish metrics on their balance sheets. Specifically, there are three metrics in play, all of which are financial ratios: RONA (return on net assets), ROIC (return on invested capital), and IRR (internal rate of return).
How does hoarding cash help these ratios? Well, imagine you're in charge of a large public company, and you're sitting on millions. Every three months, investors are picking apart your balance sheets. You need to show them you're using your capital efficiently. If you invest millions in long-term projects with no discernible short-term payoff, what does an investor see? Only a reduction of cash with no measurable increase in these ratios.
For instance, consider the IRR metric. It increases when the time span for your investments is shorter. So, for public companies, there's a metric-based motivation to favor quick-win uses of your cash stash, instead of the long-term, cash-absorbing projects that often drive the most important innovations.
You can see the problem: It's classic short-termism. These metrics don't measure growth. All they measure is how efficiently a company uses capital in the short term. Christensen's point is that investors' dependence on these metrics makes game-changing innovations seem like lousy investments, since those innovations typically take at least five years to pay off.
The larger danger? Companies look better on the balance sheet if they hoard their cash--or spend it on low-risk, short-term, in-the-box, incremental innovations.
So they replace old products with new models. They find ways to cut the costs of making the products they already make.
But they do not create revolutionary products like the car, the radio, or the personal computer. They do very little that would involve adding employees to the payroll or investing in assets with long-term horizons.
The result is an era of large public companies tweaking TVs and watches.
All while they sit on piles of cash, for the sake of looking good on paper.
The Perils of Going Public
After the talk, I asked Christensen about the implications for entrepreneurs. So many of them dream of going public. The cash. The prestige. The gaudy NYSE listing. But would they dream of going public, if they knew how badly it would hamper their ability to spend capital on long-term, high-concept projects?
Christensen shared a metaphor about going public that Ratan Tata of India's legendary Tata Group once shared with him. "When you take the company public, you have to take the shingles off the roof and install clear plexiglass. And you can't hide." Whatever you do, however you spend your money, there are investors seeking answers and demonstrable efficiencies. It's not conducive to long-term thinking or solving next-generation problems--the problems that are so nascent, they are difficult to verbalize or quantify.
This is one reason Avi Steinlauf, CEO of 600-employee Edmunds.com, has given for staying private. "Remaining private and nimble enabled us to swiftly make multi-million dollar investments in the infrastructure to support a new sales initiative whose success depends upon an implementation over many years," he writes. "We were able to make these long-term investments without worrying about what effects they might have on near-term publicly reported earnings."
Likewise, it's quite possible for private companies--and family businesses in particular--to thrive after economic downturns. Public companies have to make a display of cost-cutting during recessions. Private companies, by contrast, can invest aggressively and weather the storm. "Had Edmunds.com been forced to address the market's expectations during the 2008/2009 contraction in our industry, we almost certainly would have had to gut our organization to slash costs," notes Steinlauf.
"However, our executive team had a firm belief that the financial crisis would be temporary, and as a private company, we were able to take a calculated risk to maintain our workforce." As a result, after the downturn, Edmunds rebounded quickly. "We were able to keep our 400+ staff intact and have since grown to nearly 600 strong," Steinlauf writes.
Christensen pointed out that recession-spending paid off famously for Andrew Carnegie, too. "He doubled up in every downturn," he said.
Of course, you don't need to be a family business, strictly speaking, to have a long-term vision. For example, Carey Smith, founder and CEO of Big Ass Solutions, a $122-million manufacturer of colossal fans and light fixtures based in Lexington, Kentucky, talks about his company in terms of a 200-year horizon.
Months ago, Smith changed the company name from Big Ass Fans to Big Ass Solutions to reflect this next-generation outlook. "Simply fans is not a vision," he told me. "I do not want to suggest that the fans are not going to be a part of what we do. But 50 years from now, it’s probably not going to be mostly a fan company. You can't put blinders on like that."
Granted: You might still dream of going public one day. Entrepreneurial spirit has many layers. For some, the recognition and immortality of a public listing are root-cause motivations. But Christensen's clarion call about the capitalist's dilemma provides a provocative reminder about the flipside of a public listing: Answering, first and foremost, to investors--and the short-term metrics that they value. As Steinlauf notes: "There's much to gain from a thoughtful decision to stay private.
"After all, we are all in it, or should be in it, for the long-term."