I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Friday, July 31, 2015

Capital Structures and Organizational Pathologies: Tech Investments in Debt-Fuelled Capital Intensive Companies

Portrait of a growing company: a corporate parent with two-thirds of its enterprise value in debt, running two separate but interdependent divisions: a capital intensive asset heavy business, and a cash generative consumer-focused operating firm.

If you're the CFO, your primary concern is the debt capital that's financing your growth. You want to keep your credit rating strong to minimize the cost of rolling over debt (to finance existing assets) and the cost of raising new debt (to fund expansion). Every extra dollar paid to service the debt is a dollar less yield the business generates for its own use.

The CFO keeps the credit rating strong by having consistently strong cash flow from operations.  Even if it doesn't generate enough cash flow to cover investing activities, strong and consistent cash flows show financial discipline in running the business, and potential for financial reward at greater scale; this encourages more investment and suggests only modest risk.

The two divisions have decidedly different cash needs.  The asset-heavy business consumes capital, while the asset-light operating company generates it.  There isn't much you can do to squeeze operating cash flow efficiency from the asset-heavy business, aside from minimizing overhead costs associated with investing activity.  But you can squeeze the operating company for efficiencies, reducing total labor costs with things such as customer self-service.  The more cash hungry the asset-heavy business is for investment, the more ruthless the operating business will be squeezed for efficiencies.

The P&L is also a source of trouble for the CFO. The expanding asset-heavy division will have more expenses than income.  It isn't a problem for a growing business to post losses, but the volatility of investing activity in the asset-heavy side of the business will put downward pressure on the credit rating.  That will lead the CFO to be creative with the income statement, through things like capitalization.

What does all of this have to do with software?  The asset-heavy division isn't going to be very software intensive.  The operating company is, though.  Suppose that the operating company is in a firefight for market share, where the primary weapons are customer-facing technology (as is happening in retail, entertainment, and, to a lesser extent, airlines - all of which have capital intensive asset-cos side-by-side with cash generative op-cos.).  With labor demand outpacing supply in tech, engineers and designers are expensive. They have to be compensated in cash, since the capital structure makes it difficult to compensate them in equity.  Plus, not being an engineering firm, the company will be slugging it out to find and retain qualified engineers.  From the CFO's point of view, software development - just some part of the operating company - has a spiraling cost of labor, and it's high-maintenance (e.g., requires a lot of care and attention to get and keep people) to boot.

This is where the "we have a software company within" myth starts to fall apart.

The economics of running a competive software business don't matter a damn to a CFO who is trying to sweat every penny out of an operating company.  True, having the patina of a tech business could juice the valuation, but only in terms of the equity, not the debt - primarily because tech firms just aren't financed with debt.  If you're going to debt markets, you need financial operating cred more than you need to show tech characteristics.  Plus, the growth that mollifies the credit raters enough to turn a blind eye to the saggy P&L will have been priced into the equity; in an asset-heavy business, tech will be priced in as a necessary cost of the operating company, not as an option call on the potential for explosive growth.

Another way to look at it is, any increase in the equity value that results from the appearance of being a budding tech business is a nice-to-have for management (who have equity & options). Otherwise, with such a large debt overhang, any tech patina isn't likely to have any real economic value, e.g., the creation of an inflated currency (the company's own stock) with which it can favorably engage as an acquirer of other companies.

The opco may need tech to be competitive, but that won't be the first priority.  No matter how important tech may be, financing the debt will always trump it.  For the CFO, the priority is cost discipline.  In execution, the CFO will keep tech leadership on a short budgetary leash, forcing it to choose between hiring a lot of people but not paying competitive wages / contractor costs (and, on average, have a lower skilled engineering staff), or hiring / contracting at market rates but not being able to hire nearly the number of engineers it needs.  Either way, software development is starved for investment, crowded out by the demands of debt finance.

Accounting treatment of the software will also have its effect.  Its penchant for large capital investments on the asset-heavy side of the house will lead the company to make large capital investments in software.  Because the CFO capitalizes software development costs, the company can't afford for those investments to fail, because a failure requires the entire cost to be written off in the current accounting period, which puts a dent in the P&L.  This means that the company isn't predisposed to R&D through software (making a lot of little, experimental investments); it's predisposed to making large, debt-fueled asset acquisitions and making good on the convenants that go along with them.  In practice, the company will inject more capital into distressed software projects rather than let them fail.

The portrait of a growing, debt-fueled, capital intensive business is the antithesis of a modern software company.  Software companies are high-risk businesses: investors wager that the people in the firm can not only create interesting technologies, but can find users for them, and ways to monetize them.  The predictability and stability demanded by debt service obligations don't give rise to innovation and disruption; they create stagnation and sclerosis.  That puts paid to any suggestion that a debt-fueled, capital intensive business is really a software company in disguise.

Next month, we'll look at other operating pathologies driven by the capital structure.