Capital deployment.

In a wonderful conversation this week with a 5-10 year startup now producing over $40 million in annual revenue, spitting off lots of profit, I was pleased to hear the co-founder admit he struggled with a common problem I see happening right now in professional practices throughout the world–the problem of capital deployment.

It’s hard to imagine the fact that 20% of the U.S. dollars in circulation right now were printed in the last 12 months. Monetary supply is through the roof. Consumers are out spending again. I observed a sold out crowd at Wrigley Field a few weeks ago, as the Cubs took down the St. Louis Cardinals 7-2. The economy is hot. People are spending money and business owners sitting on capital don’t know where to deploy it.

In times of a cash surplus, do you build up the bank balance, pay down debt, distribute cash to partners and shareholders via dividends or do you invest in marketing, human capital, expansion and acquisition?

As I quickly discovered in business school, there are no easy answers to this question and the right answers are often elusive because we’re not prepared to see them.

Most of you reading this article did not inherit a huge business from your family. Some of you purchased a small business and grew it and most of you built your enterprise from scratch. While the average member here has a $2.5-3.5 million annual revenue, there are some who are just starting out and many above $20 million. 

Prior to DSOs and P.E. backed large groups, there weren’t any dental or orthodontic practices controlling more than 1-2% of the overall market share, placing next to no one above the $120 million mark in annual revenue, so I’m still very much teaching to and coaching business owners at the small to medium-size benchmark. While I have friends and mentors in the medium-to-large and publicly-traded categories, for the sake of brevity, I’m going to leave them out of today’s decision-making tree, with the goal of helping you, the owner of a small to medium-size business, in deploying capital.

Like many of you learned in medical or dental school, when triaging a patient, the top priority is acute care or survival. It doesn’t really matter how beautiful your lip revision surgery or rhinoplasty was for the patient if they aren’t breathing with an in-tact central nervous system, right? The same is true with business. The first objective is to survive.

This might sound a bit terse or flippant but I don’t mean for it to be. I’m being serious when I talk about survival. Most small business owners never knew they were 6 months away from bankruptcy, or less, until the coronavirus pandemic hit. I hope you’re taking my advice to have 8-12 months of cash on hand to survive any downturn. It’s not a theoretical exercise. 500,000 dental health care workers were laid off, a number that stunned Roger Martin, Professor Emeritus and retired dean of The Rotman School of Management at the University of Toronto, when I shared it with him. That happened because dentists ignored the first principle and top objective in business: survival*

* For what it’s worth, laying off 500,000 dental health care workers in a matter of days or weeks might have felt like “survival” but there is a long, long tail to this historic event that, it appears, I’m the only person talking about. Short term panic by the majority of dentists and orthodontists set in motion a significant destruction of trust that will take decades to repair. These are the types of events that historians give names to and politicians create laws to correct. We’re only getting started with the conversation about more protection and rights for workers in the United States. Ten years from now, if you don’t like the regulatory burden placed on you by states and the federal government, you can thank the collective action by dentists everywhere who didn’t have enough cash in the bank to prevent a half-million employees from being laid off. This fact might sting, but that doesn’t make it any less true. Back to the first lesson: survival…

Survival means you must avoid excessive risk taking, ensure proper financing, capacity, inventory and liquidity. You do everything you can to protect your brand promises, unique selling proposition, key personnel, service steps and everything that differentiates you from the competition. If you have a windfall of profits and you haven’t done these things first, this is where you start. 

I’ve written about and shared the importance of a monthly cash flow statement from your CPA. I didn’t take the time to go through those steps with you for my health. They are critical and priority #1 for everyone reading this report. 

If you want to take a deeper dive on the principle of survival, look into the physical media storage companies in the early 2000’s: At their peak, 943 million physical CDs and $5.2 billion of VCRs were sold each year in the United States. How prepared were the companies that produced compact discs and VHS tape when they assumed Blockbuster would never go out of business and the iTunes store would never replace physical albums? Unfortunately, they didn’t protect the aforementioned areas of the business and they failed to preserve the free cash flow needed to pivot. Instead, in a race to the bottom, selling the cheapest for the most volume, they slowly dug their own graves.

After survival, the next principle in deploying capital is to avoid following the crowd. Once you’ve noticed a bunch of people doing something, like investing in GameStop or AMC, it’s probably too late. Just because competitors, investment advisors or bankers point out that “everyone” is doing something trendy in capital deployment, does not make it a good idea. In fact, the opposite is often true. 

When Warren Buffett bought BNSF railroad for $34 billion in 2009, literally no one else was looking into buying railroads. That’s exactly why there was an opportunity and Buffett stepped in. When you can acquire assets, talent or new customers for much less than your assessment of their long-term intrinsic value, you must acquire them.

This is where my conversation with the $40 million co-founder got interesting. He said early into his company’s startup, they were terrified to run out of cash. They ran the business extremely lean until revenue started to pop, but even then something unexpected happened. He had amassed sizable sums of cash in the bank, but he was paralyzed when it came to deploying the capital. He and his co-founder were taught from the very beginning to preserve cash, keep the lights on and be conservative when it came to making investments.

But, just like your body needs food, water, nutrients and rest to grow, a business needs investment and cash to grow. In fact, growing companies need a ton of cash to grow (3-10X more than their non-growing competitors). He knew this fact but didn’t know where to confidently deploy capital. Eventually they figured it out, as their core group of employees started to burn out.

They had to make better and quicker investments in human capital. This was the bottleneck in their business and when they got smart and comfortable spending cash, the business grew exponentially from just under $5 million to over $40 million in less than 3 years.

Million-Dollar Exercise: Where in the business are you failing to spend money to make money? Hint: the three most-common areas when I get under the hood of most professional practices are (1) Human capital – truly hiring the most talented personnel, those way above the average in your industry, (2) Marketing – effective marketing and advertising requires significant investment. When you do it right, it always grows the business and (3) Capacity – opening more consumer-friendly hours during the evening and weekends and scaling the systems required to achieve this.