In many business courses the material pings back and forth between business and corporate. As the two terms are sometimes used interchangeably, it is not easy to understand the difference between corporate and business. So, what is the difference?
In this post we aim to create a better understanding of corporate and its relation to business.
In a previous post we discussed the topic of business strategy. We outlined that a business is the trade of a good or service in exchange for some money. If demand exceeds supply, simply making the good or doing the service is enough to have a successful business. If supply exceeds demand, you need a business strategy to be competitive and successful.
The business strategy is a plan that defines the unique set of specific attributes the firm chooses to focus on aiming to achieve superior long-term return on invested capital.
The functions and activities within the business support the execution of this plan. The business manager decides how to employ the available capital such that it creates a surplus. For a starting business, the surplus created often is equal to the net profit at the end of the year.
If a business creates profit, or surplus financial capital, the business manager has the choice to either reinvest the capital in the business or return the capital to the shareholders. For a young and growing business it’s important to reinvest all the surplus created to support future growth. The reinvested capital, the available capital and the employed capital helps the firm execute its business strategy and achieve superior long-term return on invested capital.
Returning Capital to Shareholders
In the shareholder business paradigm, it is the goal of a business to maximize the value of the shareholder. The business should return the value to its shareholders if reinvestment creates less return on investment than the cost of capital.
Herein lies a fundamental problem: is it possible to return all excess capital to the shareholders?
For excess financial capital, this is reasonably easy as you can use dividend payments or initiate a buy-back program. But, what about other excess capital?
For example, a business creates value for its shareholder by increasing the operating margin making its manufacturing process 20% more efficient. Thus, to support the manufacturing operations the business only needs 80% of the available machines. The surplus of machines represents excess capital not reinvested in the business. It’s not easy to return this surplus to the shareholder unless you sell the machines and turn them into surplus financial capital.
A common-sense solution to this problem is for the business manager to use the machines for another business activity. This is diversification and represents one of the three available corporate strategies.
From the problem described in the previous section emerges the role of the corporate.
The purpose of a corporate is to employ excess capital surplus created by its businesses to maximize the value of the shareholders. It does so by diversifying the business portfolio, deepening the business operations with vertical integration, or expanding the business operations geographically with globalization.
The corporate functions required to support the activities include the COO (operations), CMO (marketing), CTO (technology), CEO (executive team leader), and more. The functions exist to support the corporate drivers of shareholder value:
- Strategic drivers
- Revenue growth
- Duration of revenue growth
- Operational drivers
- Operating margin
- Investment in fixed capital
- Investment in working capital
- Financial drivers
- Effective tax rate
- Cost of capital (WACC)
Example of Surplus Non-Financial Capital
The example of excess surplus capital that is difficult to return to the shareholder mentioned earlier is not ideal. As pointed out, you can sell the machines and return the value to the shareholders with dividends or buyback.
A more interesting example is to look at human capital. Let’s consider the business employs a talented engineer who turns an idea in a commercial product. Throughout their career at the firm, the engineer will learn about new processes, technologies, applications, etc. Ideally the business would use everything the engineer knows to create more surplus, but that’s hardly ever the case. So, there is excess surplus human capital.
Following the shareholder paradigm, if the return on reinvestment is not an option then the value should be returned to the shareholder. But how to return excess surplus human capital?
Using the corporate strategy of diversification allows you to reinvest this excess human capital. In this example, the engineer could be assigned to work on a product for a related business.
Corporate with One Business
Another interesting topic is to consider a special case: the corporate with only business.
If the purpose of a corporate is to employ excess capital surpluses created by businesses so it maximizes the value of the shareholders, this still holds for a single business. The corporate functions that support the strategic, operational and financial value drivers still exist. It’s just that there’s a lot less to do in a corporate with a single business. You don’t need additional people to perform those functions. The responsibilities can be assigned to people already employed in the business.
Completing the Circle
A consequence of the corporate dedicated to the employment of excess surplus capital is that it encourages good business strategy. After all, in a competitive market the most excess surplus capital will be generated by businesses with successful business strategies. In that regard, we could say that as a rule of thumb the people in leading corporate functions should be concerned with the businesses in the group and their strategies.
Regarding business strategy, feel free to read through What is (Good) Business (Strategy)?.