Marsh Business Advisors, LLC
"CAPITAL"
If You Fail This Pop Quiz Your Firm Could Be Next
By: Stuart Wm. Marsh
President, Genesee Capital, Inc.
July 23, 1993
Why are some companies able to borrow huge sums of money, or sell lots of equity, while other firms are shunned by bankers and investors?
This is a timely question because today many businesspeople are bewildered when their firm, which has been in existence since the turn of the century, is being told to leave its bank, while that brash, upstart 2-year old company across the street just closed on a multimillion-dollar loan package.
The answer to this puzzle is relatively simple, and even more straightforward when answered in connection with the following broader, more basic question. What is the fundamental purpose of a company?
Instead of simply giving you the answer (which, as countless teachers have told us, would "detract from the learning process"), let's work toward the answer through that scourge of our academic youth: the pop quiz!
Keeping in mind that it's summer, that school's out, vacation's in, pressure's off and not all brains are on, let's make this exam multiple choice. Select only one of the following possible answers to the question: What is the fundamental purpose of a company?
A) To build a better mousetrap
B) To perfect a new technology
C) To beat a competitor
D) To provide jobs for workers
E) To provide a job for the business owner
F) To allow the business owner to make decisions without interference from others
G) To pay taxes to support government
H) To be a "good corporate citizen"
I) All of the above
J) None of the above
Although an engineer might select A) To build a better mousetrap, this is incorrect. Venture capitalists around the world receive innumerable business plans each year from inventors seeking financing for their brilliant new product, the majority of which are truly worthwhile. Only a fraction of these financing requests ever obtain funding, however, and only a handful of these ever make it to market.
A scientist might choose B) To perfect a new technology, but this choice also is incorrect. Consider Hampshire Instruments Inc., which developed laser-generated X-ray lithography technology for printing integrated circuit patterns on semiconductor chips. Hampshire Instruments raised more than $75 million in debt and equity from banks and venture capitalists since it was formed in 1984, but never was able to generate enough revenues and profits to be viable. In May, the company went out of business.
A sales manager might argue that C) To beat a competitor is the proper answer, but he would be wrong. Think of all the companies that succeeded in beating their competitors on price, quality, or performance, and then went bankrupt or out of business. Laker Airways, People's Express, W.T. Grant's and Gold Circle Stores all come to mind.
A union leader or a politician might say the purpose of a company is D) To provide jobs for workers, but they would be, unfortunately, totally wrong. The proof is merely to look at those economies that adopted a policy of full employment and see what has happened. The Soviet Union, Poland, Yugoslavia, East Germany, Czechoslovakia, Albania, and Romania all collapsed. Even China, where there is no unemployment, is moving toward a free – market system. One day soon Cuba also will collapse. All of these countries had zero unemployment, but the inefficiencies created by this system caused massive shortages of wanted goods and surpluses of unwanted goods. Everyone worked, but few benefited from their toil.
A business owner will pounce on E) To provide a job for the business owner. Alas, he will be sadly mistaken. If this choice were correct, then logically, everyone would open their own business and viola! we'd be back to zero unemployment. The recent employment statistics out of Washington confirm we are not enjoying zero unemployment.
Having been relieved of the notion that the purpose of a company is to provide a job for the business owner, he might then find solace in F) To allow the business owner to make decisions without interference from others. Our hapless hero's self- confidence will be eroded further upon learning that this choice also is incorrect.
Power corrupts, and absolute power corrupts absolutely. If you know everything, and need no input from anyone else, then your Divine Omniscience should not be engaged in so lowly an endeavor as commerce; rather, seated at the hand of God, you should be eradicating disease, pestilence, war, and poverty. You also may wish to consider preventing our sun from burning out sometime in the next 4 billion years or so.
Politicians and bureaucrats will choose G) To pay taxes to support our government. NOT! Every businessman or woman knows what politicians and bureaucrats either don't know or refuse to admit: Companies don't pay taxes, people pay taxes. The taxes a business pays to the town, village, county, state and federal governments simply are collected from someone else - its shareholders, customers, or employees - and transferred to the taxing authority.
If paying taxes to support our government was the fundamental purpose of a business, then surely New York, with its massive, expanding, well paid government bureaucracy, must have an enormous and growing number of highly profitable manufacturing, wholesaling, retailing, and service companies taking risks and working hard, just so they can pay those taxes.
Social activists probably would vote for H) To be a "good corporate citizen." But guess what, this is not the right answer. In Rochester, we have two excellent examples of "good corporate citizenry": Eastman Kodak Co. and Wegmans Food Markets Inc. These two fine companies could be models for the rest of corporate America. Both take excellent care of their employees in the form of wages, benefits, career growth, pensions, profit sharing, educational benefits, maternity leave and childcare.
Both actively promote minorities and the disadvantaged, and both donate huge sums of money to the United Way and other worthy charities. Both are highly concerned with the environment, and both avoid operating in markets where human rights are being exploited. These two firms also happen to be world-class leaders in their respective markets.
Yet one is undergoing traumatic changes, including selling off major product lines, and reorganizations, including job freezes and layoffs, while the other is expanding rapidly by opening stores in new markets, and opening improved "super" stores in existing markets. As unthinkable as it may sound, one of these good corporate citizens needs to make significant changes, or it might cease to be a corporate citizen
Obviously, I) All of the above, is incorrect because the rationale for each of the multiple-choice selections has just been unceremoniously dismissed.
That leaves us with only J) None of the above. The dedicated reader may conclude that this exam has both components necessary to constitute a lousy test: a lousy question and lousy choices!
Fear not! The correct answer to the question, what is the fundamental purpose of a business, is (drumroll, please) to generate an adequate return to the investors in the business. An "adequate" return is one that is sufficient to compensate the investor for both the expected risk assumed and for the expected rate of inflation.
If a business fails to generate an adequate return on its capital, then the bankers and investors will withdraw their capital from the business over time and employ it elsewhere in an effort to earn an adequate return.
If the bankers and investors fail to earn an adequate return on their investments, they, too, will go out of business. If you don't believe me, think of all the commercial banks, savings banks, and insurance companies (which are major suppliers of capital) that have gone out of business in the last five years alone. Bank of New England, Goldome, Monroe Savings Bank, Columbia Savings Bank and Executive Life all spring to mind.
Clearly, all the other choices I've listed, from building a better mousetrap to being a good corporate citizen, are critical functions of a company. In fact, I can see how company slogans such as "Let's find a cure for cancer!" or "Let's beat XYZ," or "Zero Defects!" would be far better motivators than, say, "Let's generate a 17.5 percent return on invested capital!" Without generating that adequate return, however, the company will have no access to capital and, therefore, will be unable to achieve any of its other goals.
Interest rates on U.S. government securities currently are very low because investors see virtually no risk in lending to Uncle Sam, and expectations for inflation also are very low. For this level of risk, investors perceive an adequate return. RJR Nabisco recently shelved a planned stock offering because the company wanted to sell the stock at $17 to $19 per share, but investors said they would be willing to buy the shares only at $14 to $15 each. The investors looked at RJR's historical operating performance, its leveraged balance sheet, the probability of dividends being declared and paid, the troubles associated with the tobacco division, and the competitive pressures faced in the supermarket aisles, and concluded that if the price had to appreciate to $X per share in the future, then, given all the risks, their investment would have to grow from a beginning value of $14 or $15 per share, and not from $17 or $19 per share. Simply stated, investors did not perceive an adequate return for the risk RJR Nabisco presented.
We recently invested in a company where the stock was priced at 25 times last year's losses. Yes, you read correctly. Although most stocks trade at some multiple of last year's earnings, this transaction was priced at a huge multiple of last year's losses. This planned stock offering of $1.5 million was closed out after raising a total of $5.5 million, or almost four times what the company hoped to raise.
How is this lunacy explained? Because the investors gauged the risks, calculated the expected return, and concluded that we would receive an adequate return on our investment.
Why does Paychex stock trade at 40 times last year's earnings, when companies trade at an average of 20 times? Because investors are convinced that even at that high price they will receive an adequate return on their investment. If they didn't, investors would sell their shares, and the stock price would fall.
Why was Rochester Community Savings Bank's recent convertible preferred stock offering so well received by investors when current investors are so disgruntled by the common stock's performance? Because the new investors anticipate being adequately rewarded for the expected risk they are incurring, probably through an acquisition in which another bank pays a premium for RCSB's stock.
The lesson here for business owners is to establish a goal of providing an adequate return to your capital suppliers. If the banker says no to your loan request, work toward making the loan less risky. If investors aren't snapping up your stock offering, restructure the offering to generate a higher return.
Investors - be they bankers making loans or venture capitalists, individuals, or pension-fund managers buying stock - are seeking the highest return for a given level of risk.
Companies that offer high risks relative to expected returns fail to obtain the requested debt or equity. Businesses without access to capital stagnate and eventually disappear; and contrary to the frantic bleating of politicians who may attempt to prop up these weak companies with taxpayers’ money, these firms should go out of business.
It's strong companies, the ones that are smart enough to perpetually generate an adequate return for their lenders and investors, which deserve to stay in business and prosper.