Economic downturn may intensify ongoing tensions between inside owner-managers and their outside inactive shareholders, particularly in family-owned companies.
Some outsiders view their shares as a poor investment, unmarketable, too concentrated, too little return, and subject to too much control by insiders who divulge too little information and who enjoy lavish undisclosed perks not shared with outsiders.
Conversely, insiders may view outsiders as detached investors, uninterested in the growth of the business, unappreciative of insiders’ hard work, too focused on distributions, too vocal with unsophisticated advice and criticism, too willing to inject family concerns into business decisions.
There’s general agreement that all shareholders should share a healthy spirit of enterprise. But according to Professor Ernesto Poza of the Thunderbird School of Global Management, there’s precious little published guidance about how outsiders and insiders can play well together.*
Enter Warren Buffett, the sage of Omaha, Chairman CEO and driving force behind Berkshire Hathaway Inc. Buffett is one of the business world’s great explainers. In a recent interview he dazzled television host Charlie Rose with his lucid explanation of how the United States got into its current economic predicament.
In his 1999 letter to Berkshire Hathaway shareholders, Buffett included an “Owner’s Manual” (extracts below) designed to illuminate insiders’ roles and clarify outsiders’ expectations. The italicized annotations and underlines are mine. For the full text see: http://www.berkshirehathaway.com/owners.html
Owner-Related Business Principles
- Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
- In line with Berkshire's owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.
Most directors are invested, but not all. Whether closely-held or public, companies need the objectivity and detachment of at least some outside directors who don’t own a significant stake.
- Our long-term economic goal…is to maximize Berkshire's average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.
Keeping track of detailed performance is equally important for closely-held companies: each division, each location, each profit center. Primary attention to sheer size can be misleading. Devils hide in consolidated financial statements.
- Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses…
Control if you can. Partner if you must.
- Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.
Summaries can be opaque. Look for and expect transparent details.
- Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.
Growth potential trumps income potential.
- We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. (As one of the Indianapolis "500" winners said: "To finish first, you must first finish.")
We are reluctant to borrow. If we must borrow we want long-term payback at fixed cost.
- A managerial "wish list" will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
We insiders don’t plunder the company. We don’t pay a control premium without counting its cost benefit to shareholders. We try to apply the Golden Rule.
- We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.
We know shareholders want dividends. We don’t retain earnings without economic justification in the shareholders’ ultimate interest.
- We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance — not only mergers or public stock offerings, but stock- for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company — and that is what the issuance of shares amounts to — on a basis inconsistent with the value of the entire enterprise.
Your shares won’t be diluted unless we think you will ultimately benefit.
- You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.
We are reluctant to sell winners, reluctant to discard well-managed disappointments that generate cash, and reluctant to throw cash at loosers.
- We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private.
You are entitled to know what we would want to know if our roles were reversed…
- Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say "no comment" on other occasions, the no-comments become confirmation.
…but we can’t tell you more about our stock market activities than we’re required by law to disclose. We can’t disclose information that competitors might use against us. We don’t respond to rumors.
The frustrations of air travel would be markedly reduced if gate agents would simply tell waiting passengers what they do know about flight delays as soon as they know it. Warren Buffet has a similar notion. Take the initiative with outside shareholders. Tell them what you can and why, then tell them why you can’t tell them the rest. Repeat these tellings regularly. Anticipate shareholder discontents and deal with them promptly and candidly.
Professor Poza contends (and I heartily agree) that outside shareholders of family companies should be treated even more transparently than shareholders of publicly traded companies. This heightened transparency is a quid pro quo for the opportunity to grow their “patient family capital” over long term horizons. According to Business Week, the payoff from patient family capital has yielded a 6.65% greater return on assets and return on equity (1992 through 2002) than their management controlled counterparts in the S&P 500.
Poza insists that being an owner (insider or outsider) is a job, though different and separate from being a manager or employee. Job descriptions for all owners should require them to: (1) become financially literate (2) define reasonable returns and demand those returns from management (3) provide the values and principles of doing business and ensure they remain instilled in the company (4) define the family’s strategy and communicate family economic and non-economic priorities to management, and (5) design an ownership structure that perpetuates the company’s agility to turn on a dime.
It’s too much to expect every shareholder to educate and inform themselves to the point of business sophistication. Some won’t, others can’t. But every shareholder can participate in enlightened family ownership. Ordinarily, it’s up to owner-managers like Warren Buffet to hold the light.
*Ernesto Poza, family business consultant and Professor of Global Family Enterprise at the Thunderbird School of Global Management, in an article soon to be published in Advances in Entrepreneurship, Firm Emergence and Growth. Professor Poza’s remarkable book Family Business 3rd Edition is due for publication in early February 2009.