One requirement to preserve your business structure and limit your personal liability is to adequately capitalize your business entity. But what exactly is considered “capital” in your company? Capital can be any asset, whether tangible or intangible, that is held in your company for the sake of long-term investment.
Small business capital can come from three different sources:
- Investors. For business start-ups, the investor is typically you. However, it is common for outside investors to provide capital in small businesses as well. When you invest money as capital into your company, you typically will not receive that capital investment back until you sell your business. This often scares small business entrepreneurs from investing any of their personal cash or savings as capital in the first place. You will often find that outside investors hold the same hesitancy when investing in a small business; so, many investors prefer a loan structure over a capital-contribution structure.
- Retained Earnings. Retained earnings are the earnings of the business that are not otherwise distributed to you or your investors as salaries, bonuses, dividends, etc. and are thus retained by the business. These earnings are reported on your balance sheet and they evidence that (a) your business operated at a profit, and (b) you, as the owner, had the discipline to leave this capital in the business instead of distributing it. For business start-ups, this type of capital is often very hard to attain, and is thus the least common structure for capital investment.
- Borrowed Money. Loans are, by far, the most popular form of capital investment in a small business. Loans do not have to just come from a bank; loans can come from family members, friends, investment groups, private equity firms, or private investors. When raising capital through borrowed funds, remember two things: (1) the interest, and most often the principal, must be repaid systematically in the form of established, regular payments, and (2) your business must have sufficient cash flow in order to make those regular payments.
So, how do you know if you are adequately capitalizing your business?
Begin by asking yourself “Am I able to pay all of the expenses, including the re-payment of debt, that are necessary to operate my business?” Project your sales, estimate how long it would take for you to collect your receivables, represent the capital needed and when you would need it. This gives you your operating cash. If you are unsure of how to work with these numbers, find an accountant to help you adequately assess your capital needs.
Not only should you plan for short-term capital needs, but long-term needs as well. I tell all of my clients to plan for growth: making large capital purchases? Hiring employees? Researching and/or developing any new products? Avoid using your operating cash to make large capital purchases. Instead connect with a commercial banker to get an equipment loan with a low interest rate and fixed terms. You will want to use your own retained earnings for growth and future needs; this may feel like a lofty goal, but sufficient planning and baby steps will get you there!
Remember: It takes more capital to stay in business and grow it successfully than to start it in the first place. Always be planning for growth!