Capital Allocation as an Antidote to Business Luck

This is Part 7 in a series on the expertise of capital in business. You may read the previous part here.

Last week’s essay was about capital allocation. It was not shared as widely as I had hoped. This isn’t too surprising: Buffett has been talking about capital allocation for at least four decades now; long-term investors have known about the importance of capital allocation for about as long. But capital allocation as a topic has never been particularly attractive to business operators. This is partly, I think, because it’s such a foreign concept (“You mean I have to think like an investor? Gimme a break — I have to deal with goddamned competitors and I’m looking for a moat to keep them at bay and yesterday my head of sales told me she was quitting. I’m dealing with stupid business-related fires every day.”) But perhaps it is also unpopular because it is so unsexy. Good capital allocation can only be celebrated after a period of decades — it is never amazing in the moment. In this manner good capital allocation is a little like good parenting.

As an operator, I agree with both sentiments. I once described business as an ‘octopus game’; in Prioritise the Highest Order Bit I told the story of a particularly trying time at an old company, right after we had executed our first layoffs. If you are an early-to-mid stage operator, there are often too many things you’ll need to do to keep your business afloat to worry about, uh, investment decisions. And this is also true if you are an employee, so busy making sure that the wheels of the business are turning day-to-day. In this view of the world, capital allocation seems like an abstract, academic concept.

So I’ll tell you why I’m interested in the topic. I think capital allocation is a way to ameliorate the effects of luck in business.

The Problem of Business Luck

How do you build a massive business from scratch? The glib answer is that you need to get lucky.

• For starters, you’ll need to find a business opportunity that is radically, wondrously huge, and able to grow to billions of billions of dollars. As we’ve already examined earlier in this series, such business opportunities are very rare.
• To make things worse, you need money to make money — which means that you need to capitalise this business somehow. If you are very lucky, it turns out that your multi-billion dollar business opportunity funds itself (you are Microsoft, as I jokingly said in The Skill of Capital). But more often than not you raise funding from venture capitalists or other capital providers, who are optimised for exactly this kind of growth.
• You must also be lucky to ride out the entire journey from startup to scale-up, holding on to control over the company. You must be lucky in that you actually turn out to like the business enough to run it for the long term, you are lucky because you turn out to actually be good at it, and you are lucky to not get kicked out by your investors.
• Also you must be lucky that the business opportunity is not illusory. The vast majority of startup stories is that the market shows promise but it turns out you’ve started a company in the wrong corner of this newly formed industry; a few years into your journey it becomes clear that all the profits are to be captured by some other company positioned in an entirely different corner of the market. (That company’s founders got lucky and you did not.) Or perhaps the business turns out to not be a billion dollar opportunity in the first place — just a solid 200 million, say, in equity value. If you’ve raised venture capital, then this terminal valuation is far below the VC investment hurdle rate. Oh, they’re writing you off? They’re pushing you to get acquired by another portfolio company because they want to close off the investment? So sad, you got unlucky.