Most people think the CEO’s job is to be an operator – the person in the company ultimately responsible for hiring, brand building, corporate culture, product development, sales, compliance, and so on. But the CEO’s primary responsibility is not to the business; her primary responsibility is to the owners of the business. The business is served by operating it, the owners are served by growing their capital, and those two activities are not necessarily the same. Owners’ capital grows by increasing the intrinsic value of their share of the business or by paying them a dividend.
CEOs can grow intrinsic value using capital in four ways:
- invest in existing operations,
- buy other businesses,
- pay down debt, or
- buy back shares.
Investing in existing operations – hiring people, building factories, or running marketing campaigns – and buying other businesses can significantly grow intrinsic value when done well. That ability is what separates great operators from the rest.
Paying down debt makes sense when the company can’t use the capital to generate higher returns than the cost of the debt or when holding the debt exposes the company to too much risk.
Buying back shares makes sense when the market is undervaluing the company. When that’s the case, buying back shares can be a tax-efficient way for the CEO to increase intrinsic value for those owners who choose to keep their shares.
CEOs can get capital from three sources:
- internal cash flow,
- raising debt, or
- issuing equity.
Internal cash flow is the simplest and cheapest source of capital when it’s available.
Raising debt increases risk and the interest on the debt is an ongoing cost. To increase intrinsic value, debt has to be used for something that creates enough value to offset the extra risk and interest cost — perhaps acquiring a business or a license from a regulator.
Issuing equity dilutes existing owners so capital thus raised needs to generate a value increase that offsets the dilution. In other words, it needs to produce a sufficient increase in value per share. But if the market overvalues the company and there are good investment opportunities, issuing equity can be a good source of capital.
How should CEOs choose what to invest in? They should invest in the opportunities with the highest risk-adjusted returns. If they run out of opportunities with estimated returns higher than the market, they should pay any remaining cash back to owners via either share buybacks or dividends so that the owners can allocate it as they prefer.
Taking tax implications for owners into account.
The CEO’s job is to grow owners’ capital – by growing the value per share or by paying out dividends – even if that means shrinking or selling parts of the business. For startups, by definition, the return on investing in existing operations is far greater than those of the other options and a startup CEO needs to be an exceptional operator above all else. CEOs of other types of companies need to consider all tools available for growing the owners’ capital.
There are CEOs that delegate almost all operations to others and primarily spend their time on capital allocation – Warren Buffett is the canonical example of that.
Thanks to Jan Sramek for reading drafts of this.
William N. Thorndike Jr., The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Boston: Harvard Business Review Press, )
Lawrence A. Cunningham, The Essays of Warren Buffett: Lessons for Investors and Managers (John Wiley & Sons, )
Warren E. Buffett, Letter to the Shareholders of Berkshire Hathaway Inc., http://www.berkshirehathaway.com/letters/1993.html ()
Paul Graham, Startup = Growth, http://paulgraham.com/growth.html ()