Capitalizing Your CompanyCapitalizing a company doesn't just happen in the beginning. Every company, new ones and operating ones, must deal with capitalizing issues. Especially the successful ones, because success begets growth, and growth requires capital. If your company needs capital, as the owner, you are the one who has to get it.
Webster: capital, n, any asset, tangible or intangible, that is held for long term investment. Capital, blended with cashflow, is the financial fuel your company's engine uses to, among other things:
• Buy equipment, vehicles, R&D, etc.;
• Fund growth by purchasing inventory, hiring employees, financing receivables, etc.;
• Provide reserves for those inevitable rainy days.
Three Kinds Of Capital
1. Investment Capital
This capital comes from you or someone else. It's like buying stock in the stock market except for one thing: When you make an investment in a small, closely held corporation, there is no market for your shares. Therefore, you typically won't get your invested capital out until you sell or otherwise dissolve the company. Consequently, most small businesses will have a nominal amount of shareholder capital - typically from $1,000 to $10,000 - and this investment will usually be made only at the point of incorporation.
2. Retained Earnings
This is the profits your company has made, and which you have left to accumulate in the company; which is to say, the profits you didn't take out as salary, bonus, dividend, or other distribution. Of all the forms of capital your company could have, this is the best kind, because you got it the old fashioned way, your company earned it.
Your banker will like seeing retained earnings on your balance sheet even more than equity capital because it says two things:
a) your company had the ability to produce retained earnings by operating profitably;
b) as the owner, you had the discipline to leave this capital in the company instead of distributing it.
3. Borrowed Funds
This is plain old debt; money you borrow from a bank or an individual. Debt can be an excellent way to capitalize your company. But there is one annoying little detail about borrowed money: Unlike investment capital or retained earnings, debt accrues interest, and requires debt service - payments - which creates an incremental drain on your company's liquidity.
Your business has to be able to generate the cashflow to make these payments. If it can't, you shouldn't be asking for the loan. You should know if you can service the debt before you get to the bank with your request. But if you don't, your banker will.
One of the individuals your company could borrow from is you. Instead of investing your money in your business as investment capital, you could lend it to your company. Unlike equity capital, which stays with the stock and only pays a return if you declare dividends (a rare event in small business), a loan from you to your company produces a return through interest payments, which are made by your company.
You could loan money to your company as a personal income strategy. If your company needs money and you have it, why let a bank make the interest? Plus, since you are essentially the bank, the approval process is very short. Talk to your CPA about this.
The Retained Earnings Sermon
In my opinion, the way to wealth and independence for the average person in America who wasn't born with it, is through the accumulation of equity, not the earning of personal income.
If you are an employee of someone else's company, all of your compensation from your efforts comes in the form of personal, earned income, and it is reported on your W-2 form. Yes, many companies do offer stock options. And while this practice seems to be increasing, employees who have this opportunity are still in the minority nationwide.
As a business owner you will receive a W-2 for the salary and bonus you take. But all of your financial benefit doesn't have to be earned income. You have the opportunity to leave some of the company's earnings in the company in the form of retained earnings, which becomes equity. Your equity. Some of this equity will be in the form of cash, but most of it will be in inventory, equipment, fixtures, vehicles, real estate, good will through market penetration and brand development, etc.
As long as you are in business, every dollar of retained earnings capital is making you money. Retained earnings is:
• the working capital that you don't have to borrow from the bank, or dilute your ownership with by taking in other investors' capital.
• your safety net during the inevitable period(s) of slow sales or other problems that can befall a small business,
• your financial homerun when you sell your business.
Involvement Or Commitment
Another reason to maximize retained earnings in your company is that bankers like to see a nice number on the balance sheet of a company they are considering for a loan. A history of retained earnings in a company says commitment, and bankers like their borrowers to be committed in their business, not just involved. Do you know the difference between involvement and commitment?
When you look at a plate of bacon and eggs, you can see that the chicken was involved in your breakfast, while the pig made more of a commitment. Bankers like it when you are committed.
The Smart Money
If you want to demonstrate that you practice sound management fundamentals, leave every nickel you can in your business. Think of it as paying your business first. By taking care of your business now, it will take care of you later.
So, if retained earnings are so great, why would anyone ever invest money or borrow to capitalize a company? Unfortunately for most businesses, accumulating working capital through retained earnings is a slow process. In today's marketplace, most businesses need working capital to fund growth faster than their profits will generate as retained earnings.
I think the best plan is to incorporate all three methods of capitalization. It's really very simple: Leave every cent of earnings that you can in your company, and invest and/or borrow the balance of what you need to grow your business.
If you want to own your company outright one day, which is to say no debt, you will have to begin a disciplined, long-term process of accumulating retained earnings. By amortizing your debt, you will be replacing debt capital with retained earnings capital. As I said earlier, talk with your CPA about the best combination of capital options for you.
Write this on a rock... Understanding the benefits of accumulating retained earnings is one of the most critical perspectives a small business owner can acquire. Don't get discouraged. It is a long term process, but it's worth it.