Problems – Pay Dirt

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.

There are countless articles romanticizing farming and farmers. Media and industry magazines love to talk about the art of farming as if each plant gets nourished and touched by hand or that each field is only known to the alchemist-planter who has farmed it for 35 years.

I would contest that farming is a lot more like a factory than anything else.

However, that argument justifies another full discussion.

What is different about farming from every other industry is time and space.

Time

For farms and farm related businesses there is one cycle a year to make money. Generally, a piece of land will grow one crop in a year. This means a farm will have revenues from its operations once a year. There is one opportunity to improve operational metrics and one opportunity for business growth.

Many businesses can make changes on the fly. If a restaurant’s menu item is not selling well for a month or two it can be replaced. Despite the cyclical nature of the business, a landscaping company can pick up new clients and grow their business in throughout the year. In other words most businesses have a quicker and more accurate feedback loop which allows them to make changes to their business to improve what works and cut what does not.

There are two different ways for a farm or business selling to a farm to combat this problem.

Prepare. The greatest coaches in any sport have limited control over a game once it has begun. If you read about John Wooden or Nick Saban, they focus relentlessly on process and spend vast amounts of time preparing for a very limited period where their teams can win or lose. The best farms and businesses around agriculture are the same way. They are ahead of the game; they anticipate what could happen and prepare accordingly.
Diversify. With only one chance a year to make money the best farms are those that are not wholly dependent on income from a cyclical, commodity business. Historically farms make a little money or lose a little money four out of five years. The fifth year they make a lot of money. Much of the time farm related businesses are the same. Those businesses that best reinvest their windfall are often the winners. A processing facility, a service business, or a business that is unrelated to agriculture can often supplement the income from a farm and create further opportunities to grow the farm or invest in yet other businesses.

Space

There are few businesses that continually operate over vast amounts of space. A large farm could span 40 contiguous miles. Some have different operations in multiple states. However, even for a farmer with several hundred acres many of his vendors may be the next county over.

While a line on a factory may go down, the parts to repair the machines are often on site. At other times, the pieces going into the assembly are in warehouses just on the other side of the floor. In farming the pieces going into the assembly are often 20 miles away. If a part is needed 40 minutes or more is lost in travel to retrieve whatever piece is needed. Or if a decision maker needs to see a field or a mechanic get to a broken machine the time in transit can cost thousands. There are brief windows which are optimal planting periods for various crops and often rain will keep one from using half of the days in those periods. Missing those windows can cost a farmer with dramatic yield reductions. Further a machine, operator and implement which is not running is a cost to the operation without creating any value in the form of eventual revenue.

Space is a more difficult problem to solve. Its effects can only be mitigated.

Prepare. Just as preparation eliminates many of the time problems it helps reduce the amount that space can effect any operation. A farm or agriculture business must understand how to best cover the territory over which your business spreads. Often this means positioning assets, shops or equipment strategically in order to reduce travel time. Further, working with vendors and other counter-parties in advance can ensure service no matter the location.
Communicate. Often space prevents proper communication leading to errors. Any policy, procedure or program which facilitates ongoing communication will mitigate the effect of space. For someone driving a machine over a field he has not seen before, a map can allow him to perform the correct action in the correct space and move on to the next location. If he were to spray a chemical on the wrong field he could kill the plants in that field or prevent the intended crop from going there due to chemical residue that would prevent early growth. The more often and more clearly a team communicates the less space affects an operation.

So What?

These are the two biggest problems in farming no matter what the size of the business or how it interacts with a farm.

If you can create a businesses that helps combat this problem for a farmer, you should succeed. However, many businesses are built without these problems in mind. For instance, the “Uber for farmers” idea has been bounced around countless times. A company or two has even tried this idea and failed. The beauty of the idea is that a farmer could free up his balance sheet by sharing expensive assets with others. The problem is the farmer cannot prepare for any problems that might arise. If a harvester or planter doesn’t show up in time or in good condition, there is a real possibility of losing a significant portion of his crop by harvesting or planting it late.

To build a business which can withstand these problems one must be well capitalized, anticipate problems that might arise for one’s customer and address them ahead of time. Farmers are pitched new ideas, chemicals and seed all the time with little proof that they will work as well as advertised. The data to back up assertions is rarely useful. As a result, many farming businesses are skeptical of newcomers who claim they can execute on an idea that has not been tested.

As a landowner one must consider how well adapted a potential tenant is to these circumstances. Can they manage to execute at a bigger level? Is the farmer’s primary base of operations close enough to the land?

Any business selling to farmers or buying from them must understand the ability of his customers to send or receive the goods being moved. Logistics cannot be underestimated. Not only does one have to move large amounts of physical product over vast amounts of space, but weather can often get in the way by raising rivers to flood roads, keeping roads muddy and not allowing access to points far from asphalt, and delaying the use or harvest of product for significant periods of time.

The complexity of the two differences can be daunting, but knowing and planning for them in advance does much to mitigate their effect.

Tag: Problems

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