The book The Outsiders by Will Thorndike is one of the most useful books to understand what makes a CEO or business owner great. Thorndike dissects the careers of eight CEO’s who have had long and enduring success at capital allocation.
The book breaks down both the how to raise and allocate capital and where these eight men made different decisions from others leading to their success.
One can raise capital by:
1. tapping internal cash flow
2. issuing debt
3. raising equity
One can allocate capital by:
1. investing in existing operations
2. acquiring other businesses
3. issuing dividends
4. paying down debt
5. repurchasing stock
While this framework is really just a tool to help understand what made Thorndike’s subjects different, it is a tool that can help one understand the choices which exist to a farmer, landowner, and many other small business owners.
Raising Capital
1. Tap internal cash flow.
This is the most likely source of capital. However, for a farmer or landowner with a crop share lease this cash flow fluctuates wildly. 1 out of every 5 years on average will make a farm profitable over the period. How he allocates capital in this one year will make or break a farmer. New boats, houses, and, at times, even new machinery or land improvements can be a siren song for those who need proper cash reserves.
2. Issuing debt.
While a farmer cannot issue debt, he can take on debt for new land, or, once he is big enough or has enough capital, he can get revolver debt that will help him ease the burden of down years. Most farms have one year notes that they must pay back in full every year. A terrible state of affairs for a cyclical, commodity business. Further, most debt is backed by a farmer’s entire net worth including equipment, land, savings and home.
3. Raise equity.
This option is closed to most farmers. The closest thing that a farmer can get to this is having a relative back a loan and take a stake in his business.
Raising capital for farms is a massive problem. It has been said that in order to start a farm you have to be wealthy enough to retire without one. So, why start? Surely a business that is worth doing should not require capital from previous generations to start.
Allocating Capital
Allocating capital is what makes any business profitable, but doubly so in a farming business.
1. Investing in existing operations
Farming businesses most often redeploy capital back into their business.
-This could take the form of new equipment, which increases operating capability, but also decreases cash and increases debt payment obligations both of which hurt the ability of a business to whether down cycles.
-This could take the form of buying or renting new land. However, this requires a new set of skills. The more land one takes on the greater management capability one must have. If the farmer is used to managing himself and 3 other people as well as tending to his machinery and crop health, managing a manager and two teams to do all of this is a different skill set. Further, to manage cash flows, greater crop marketing complexity, and a larger amount of debt requires a totally different set of knowledge than before. The skills of an agronomist and a mechanic are not those a capital allocator or manager and there is little in the form of training available to acquire those skills.
2. Acquiring other businesses
This is possible and a great solution. Often another business either in the same industry or another industry can give a farm cash flows not related to those derived from farming operations.
– In the same industry a farm may acquire a commercial spraying or processing facility. This could reduce the cost of this service to the farm and serve other customers allowing the fixed cost of the business to be spread across more acres than the original farm itself. However, one then comes back to the problem of having to manage multiple businesses which may not have middle management in place to run the day to day operations.
-In a different industry a business may be acquired, but previous knowledge of that business likely does not exist. Also, many businesses near farms are linked to farm income. If farm income suffers in a rural area, fewer people are buying clothing, parts, toilets and most other essential items. The whole region defers maintenance while cash flows are low.
-Finally assets in rural areas do not hold their value. There are a limited set of buyers for a commercial facility in almost any rural area. Fewer buyers usually means lower sales price for the asset. Sadly, this is true for non-farm assets like homes as well.
3. Issuing dividends
While dividends are not necessarily paid, the option exists to remove capital from the business to spend. This often happens in times of plenty. If maintenance has been deferred on a house, it needs keeping up when more money is available. If a family has been living on a smaller income, many people want to take them on a vacation or buy a nice gift if times are good. No one should be denied living well off a windfall. However, there are also no industry standards as to the appropriate amount one should take from a business or keep on hand.
4. Paying down debt
Along with reinvesting in the business paying down debt is a very common way to allocate capital in a farming business. Barring a prepayment penalty changing debt structures or paying down debt can reduce the amount of fixed cost a farm has to make in a given year. Lower fixed costs and debt payments make a farm able to withstand the low periods in the cycle. Many farms only think about their cash flow from year to year. Its common for someone to say “I have more money in my checking account this year than I did last year, so I made money.” Which would be true except that the farm should be accounting for the depreciation in the equipment and likelihood that the equipment will have to be replaced. In fact, having all farm equipment paid off is often viewed as a retirement policy. When a farmer retires, he can sell his equipment at an auction, pay down any land debt outstanding, and live off any cash and land rent that is left. This is often seen as the best way to end a career. For most, it is the only way one can end a career. Farms are not ongoing concerns. There may be better ways to use this capital, but paying down debt is often the safest way to see a return on investment when outside investments even in retirement accounts are very uncommon.
5. Repurchasing stock
Stock repurchase is most often not an option for a farmer. Maybe he could buy out a brother or sister’s portion of his business, but this is only a way to increase his exposure to the volatility of the underlying business.
There are few good ways to allocate capital in farming businesses. Often few options are apparent to the allocator because the only obvious options are those others around him have done for generations. The way to ensure success is not obvious in any business, but in farming, especially surrounded by like minded individuals, the problem is compounded. Those who can expand their business while carefully managing debt will be well positioned for continued growth and compounding.
An even better solution would be for other sources of capital to actively co-invest with farming businesses, take on some of the volatility and possibly even reduce it through greater capital stability and management.
Pay Dirt 