Whether for a startup or a large enterprise, capital allocation is one of the most critical roles that CEOs perform. Yet, capital allocation strategies vary depending on the size of the business.
Most discussions about capital allocation focus on large, public companies. This ignores startups and growth companies, however, even though capital allocation plays an equally important role with smaller firms.
For any company, there are three distinct capital allocation phases: startup, growth, maturity. Each requires a different capital allocation approach.
Let’s look at capital allocation priorities for each of these phases in the growth of a business, and how an enterprise resource planning system (ERP) will help during a given phase for correct capital allocation decision-making.
Startup Phase Capital Allocation
When a business is just getting going, it has the most constrained capital for allocation. Startups therefore will be focusing capital allocation on either the core business or new business.
For core business capital allocation, this means allocation to support organic core growth, and both mergers and acquisitions of talent or bolt-ons to facilitate core growth.
Startups also might allocate capital for new business as they discover the market and potentially pivot strategy. New business capital allocation includes allocation for organic new products or M&A for a new line of business.
- Investments will probably not generate immediate profit, but they should yield a return on investment over time. This truth can be forgotten in the flurry of setting up a business, but good capital allocation always has an eye on eventual after-tax profit.
- There is no guarantee that a project within the startup will get capital. Business pivots are fundamentally capital allocation decisions. If an activity is not working or other projects look more promising, allocate elsewhere.
It is worth noting also that these capital allocation rules for startups serve as the basis for capital allocation in later phases as well. Other phases just add additional capital allocation decisions. These two core rules should never be sidelined in any phase.
Having an ERP system in place is critically important for capital allocation during the startup phase. Because ERP encompasses all parts of a business, CEOs can easily see where capital is being allocated end-to-end. This can then help with deciding how to allocate resources within the company, and assist with determining which projects should be continued or shut down from a capital perspective.
With built-in analytics, ERP solutions such as SAP Business ByDesign also can help CEOs forecast and make financial projections about the long-term profitability of a given project or initiative.
Growth Phase Capital Allocation
CEOs at companies in the growth phase have a much larger pool of capital to work with than those running a startup. The focus of capital allocation in this phase is market capture, which means customer acquisition and building the company’s unique advantages in the market. Capital allocation therefore focuses on aggressively expanding the core business, but there also are other options for capital in this phase beyond allocating to the core business or new business.
These include capital allocation to non-controlled interest via strategic investment, and cash allocation.
Allocating resources to cash and equivalents is self-explanatory, but capital allocation to non-controlled strategic investment might be less so.
Strategic investments that ensure certain services or partnerships needed for the core business are frequently overlooked. But this type of capital allocation is highly effective for a business in the growth phase. These strategic investments in non-controlled interests often help a business with supply chain, data access, and geographic expansion, among other areas.
- Resources go to the core business first, but nothing is guaranteed. Rule #1 from the startup phase still applies to growth companies, so the core business eats first but only when it makes financial sense above and beyond other options.
- Allocation to new business or strategic investment must generate a higher return than the core business. Any capital allocation beyond the core must come with a higher eventual return than further investment in the core business. Otherwise, a company is needlessly spreading itself too thin.
- New organic business should be treated like startup capital allocation. The same rules in the startup phase should apply to allocation to new organic business.
ERP helps with capital allocation in the growth phase in several ways. First, ERP delivers an accurate picture of all operations and projects so allocation to the core business and the return on this investment can be accurately assessed on an ongoing basis and compared with other opportunities. The end-to-end visibility and forecasting functionality within ERP help with that.
CEOs also gain a much clearer picture of partner and supplier relationships with the use of ERP. This awareness of the entire ecosystem of the business and potential choke points can help with assessing capital allocation to non-controlled strategic investments.
Mature Phase Capital Allocation
By the time a business reaches the mature phase in its lifecycle, the focus has shifted from expansion to shareholder returns. Mature businesses that fail often do so because capital allocation isn’t oriented with this principal objective in mind.
The capital allocation toolbox for a company in the nature phase includes all previous options, including allocation to core business, new business, cash and non-controlled interest via strategic investments. But the options expand further.
These additional options include capital allocation to non-controlled interest in non-strategic investments in the name of capital returns, and capital allocation for returns from share repurchase, dividends, and debt repayment.
As mentioned, the main rule for capital allocation at this point in the lifecycle of a business is increasing shareholder returns.
In this latter stage of development, ERP assists CEOs with capital allocation by enabling the sophisticated financial modeling necessary for these complex allocations, and by housing all financial and operational data within a single system for accurate planning and allocation.
ERP Helps with Capital Allocation at Every Phase
As noted above, capital allocation priorities are different at each phase of a company’s growth. Also evident from the above is that ERP plays an important role in effective capital allocation no matter the phase.
By giving CEOs the tools to fully understand their business end-to-end in real-time, ERP is an essential tool for capital allocation at every stage of a company’s growth.
For more on ERP and the role it plays, download our free guide, Understanding Cloud ERP for Non-IT Executives, or contact one of our experienced ERP consultants at (801) 642-0123.