One of the things we talk about as a significant failure factor for new businesses is being under-capitalized when they start. Undercapitalizing is simply a fancy finance term for underestimating how much money it will really take to (1) get the business started and (2) to cover initial losses while sales ramp up before the business gets to breakeven.
You don’t go out of business because you lost money – you ran out of cash.
Before launching a business, make sure you have the cash on hand to see you through until you land customers and they start paying their invoices from you.
There are a number of factors that determine how much capital any small business needs to start. Businesses that offer a service usually require fewer funds than those that sell a product. This is because service businesses do not have to invest in inventory.
An example if you do not hit the breakeven level of sales until month 6:
- In the periods before month 6, your revenue has been less than your expenses. So, each month (for five months), you needed to find extra cash (Capital) to keep paying the bills.
- You appear to have a growing business, so what’s the problem? The problems will occur if you do not have sufficient capital to fund these shortfalls at any given time.
- You need to manage and understand cash inflows and outflows during this critical period and ensure you have made arrangements to have Capital available. This is what cash flow forecasts are for.
- Your brilliant business may never get the opportunity to flourish if at some point before month 6 you find yourself under-capitalized, aka, you ran out of cash.
These are the kind of things that can happen:
- You can’t pay wages, staff leave, work stops.
- You fall behind on lease payments and equipment is removed. Work stops.
- You can’t pay suppliers. They won’t ship your materials or product. Work stops.
- You miss loan repayments. Bank calls your loans. No more business.
- You don’t pay rent. You are evicted. No premises. No business.
- You can’t pay utility bills. No gas, no water and no electricity. No business.
If only those nasty creditors would wait. Things will get better eventually. Those nasty creditors may be sympathetic, but they have heard the story before, and eventually their generosity and patience will run out.
- Make sure you have a good grasp of your cash needs
- Make sure you have a cushion available to get you through the peaks and valleys that inevitably will occur.
- Your own personal funds
- Bank line of credit.
- Equity funds from a friend or family member (but, be careful here)
The second point at which a capital crisis may occur is two to four years after the business has been started. You reach a level of business at which you need additional employees, facilities, or equipment. These all cost extra money. The key with either bank financing or an equity investment is to plan ahead. Don’t wait until you start getting behind or until you have a huge order to fill before going to the bank (more likely) or investor (not very likely).
While we are on the subject of capital, we would be remiss without addressing the inappropriate use of financing as a major cause of early small business failure. There is a tendency for the new business owner to use any source of money available to finance the entity, regardless of the interest rate and repayment schedule. This can be disastrous.
No matter how tempting it may be, do not use short term financing to fund long term investment. Avoid the use of high-interest rate credit cards, accounts receivable factoring, and lines of credit, except for short-term uses.
If you have a longer term financing need, arrange for longer term financing. Again, match the financing to its use.