The Big 3s of Small Business Capitalization

Jim Blasingame The operative word in this article is capital. Webster defines capital as, "any asset, tangible or intangible, that is held for long-term investment." Capital, blended with operating cash flows, becomes 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.

Every company -- new ones AND operating ones -- must deal with capitalization issues. And not just in the beginning, but always.

As the CEO of your small business, the first sentence in your job description is, "Get the capital your company needs." It's what I call the Reverse-Truman Effect. President Harry Truman had a now-famous plaque on his desk that read, "The buck stops here!" The plaque on your desk should read, "The buck starts here!"

The Big 3
There are three BIG components you must contemplate as you take your capitalization journey of understanding, and each are divided into three parts of their own. Here they are:

1. The Three Capitalization Questions
2. The Three Capitalization Mistakes
3. The Three Kinds Of Capital

The 3 Capitalization Questions
Every future and current small business owner should ask themselves these three questions.

• Capitalization Question One: Do you know the three kinds of capital sources?

• Capitalization Question Two: Do you know how to determine your business's current and future capital requirements?

• Capitalization Question Three: Do you understand how to manage and allocate these sources in proper proportion?

The marketplace is a stern schoolmaster. If you answered "no" to even one of these questions, you failed the pop quiz. As your company's go-to-guy for capital, the deer-in-the-headlights look on your face right now should be just about to turn into stark terror. And yes, the cold sweat popping out on your forehead, and the nausea, is to be expected. But take heart -- I won't leave you like that. Read on.

The 3 Capitalization Mistakes
My little pop quiz above brings us to three HUGE -- maybe catastrophic -- mistakes that small business owners make concerning capitalization.

• Capitalization Mistake Number One: Not understanding that additional capital is required just to STAY in business beyond what was necessary to START the business. And the stay-in-business capital is often much more than the get-in-business capital.

• Capitalization Mistake Number Two: Not realizing that you can actually grow yourself out of business. Success begets growth and growth eats capital like Cookie Monster eats Oreos.

• Capitalization Mistake Number Three: Not managing the three kinds of capital to the best advantage. As in most things in life and the marketplace, the three kinds of capital have good aspects, which should be maximized, and bad aspects to be minimized.

The Three Kinds Of Capital
Small business capital comes in three flavors:

• Investment Capital: This capital comes from you or some other investor. It's like buying stock in a publicly traded firm, except for one thing: When you make an investment in a small, closely held corporation, there is no after-market for your shares. Therefore, you typically won't get your invested capital out until you sell the company. Consequently, it's common to see a relatively low number on this line item on the balance sheet of most small businesses.

• Retained Earnings: This is the profit your company has made that you left in the business; the profit 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 your business got it the old fashioned way -- it earned it.

Your banker will like seeing retained earnings on your balance sheet, perhaps even more than investment capital, because it says two things: 1) Your company had the ability to produce retained earnings by operating profitably; 2) As the owner, you had the discipline to leave this capital in the company instead of distributing it.

• Borrowed Funds: This is plain old debt; money you borrow from a bank or an individual. Debt is not only an excellent way to capitalize your company, it is the capital de jour for every small business I've ever seen.

But there are two annoying details about borrowed money: Unlike investment capital or retained earnings, debt accrues interest to the lender and must be serviced -- as in, payments -- which creates an incremental drain on your company's liquidity. Your business has to be able to generate the cash flow to make these payments. If it can't, don't ask for a bank loan, because you won't get it.

The Answers
We've answered Capitalization Question One about the three kinds of capital. But we still need to answer Questions Two and Three.

How do you determine your company's capital requirements? I only have room here for the short version. First, you must know how much you're going to sell and how much you're going to purchase, which could be for inventory, operating expenses, equipment, or even training. Then you have to estimate how long it's going to take you to collect your receivables, and how quickly you're going to have to pay for what you purchase. All of this has to be plotted out on a financial operating timeline. Along this timeline, any negative numbers at the bottom of the page represent the new capital you need, and when you need it.

How do you allocate your capital? Again, here's the short version. Don't deplete operating cash to purchase large capital items, especially with interest rates so low. Don't borrow money for operating expenses. Funding receivables and inventory arising from growth with borrowed capital is not a bad plan, but establishing a long-term goal of being able to fund growth more from retained earnings and less from debt should be Part B of this plan.

The Retained Earnings Sermon
Every dollar of profit you leave in your business as retained earnings is a step toward financial security. Retained earnings is the working capital that you don't have to borrow from the bank, or dilute your ownership with investors. It's your safety net during the inevitable period(s) of slow sales or other problems that can befall a small business. And it's your financial homerun when you sell your business.

So, if retaining earnings is so great, why would anyone ever invest money or borrow to capitalize a company? Unfortunately for most small businesses, accumulating working capital through retained earnings is a slow process. Most of us need growth capital faster than profits will generate retained earnings. The best plan is to maximize the good aspects, and minimize the bad, of all three kinds of capital in your business.

Write this on a rock... Making sure your company has enough -- and the right kind -- of capital to operate effectively and grow is arguably the most important assignment you have as the CEO of your company. But it's no hill for a climber, and you're a climber.

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Category: Financial Planning
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