Ever since people started keeping track of money, they also have been mindful of their capital, especially in business. One dictionary definition of the financial term capital is “the wealth, whether in money or property, which is owned or employed in business by an individual or a firm, etc.” But having said that, not all capital is created equal. How your business is capitalized can have a major impact on its potential for success.
To illustrate: say you are a great cook, and have a wonderful idea for a restaurant. You find a nice leased space for your new eatery, but find out that it will cost you $100,000 to do the renovations and to buy all the equipment, utensils, etc. You go to the bank, but the loan officer there says she won’t lend you all of the money—you need at least $20,000 of your own. So you scrape together $13,000 yourself, borrow another $7,000 from your favorite uncle, Joe (who says he won’t need it back anytime soon), and go to the bank for the rest.
Congratulations! You have now started up your restaurant, and also a new capital structure that
contains a bank loan, a patient loan, and equity.
The biggest part of your capitalization is that $80,000 bank loan. That’s typical for a small business. But unlike Uncle Joe, bank loans are not “patient”. Banks demand regular repayment, usually on a monthly basis. And bank money comes at a cost. If you are paying 6.50% on that $80,000 loan over seven years, the payment will be around $1,188 per month—in many cases, starting one month after you have received the loan! Early on, it might be hard for you to get
enough paying customers to make such a hefty payment, especially since you now have new utility bills, employees to pay, and insurance costs.
You may suddenly find yourself wishing you had borrowed more from Uncle Joe (assuming he has the money), and less from the bank! By borrowing only $40,000 from the bank, and the rest from Uncle Joe, you would have cut your monthly bank payment in half, to only $594. The benefit of a patient loan is that it does not need to be repaid immediately, which is particularly helpful during the start-up phase of a business. Also, in some cases, Uncle Joe might not even charge interest (although with a larger amount of money, like $47,000, he might want to have you actually sign a note evidencing the loan).
Of course, for all that money, Uncle Joe might ask for an ownership stake in your new business. You should consider this carefully. If you do it, your favorite uncle now has an equity stake in your business, and has become your partner. He is entitled to his share of the profits from the business, sometimes without doing any of the work. He also has a right to have some input about the future direction of the business. And it may not escape Uncle Joe’s notice that he has more money in the business ($47,000) than you do ($13,000).
With all of these issues, you may wonder why not just use your own money, and not be bothered either with the bank or Uncle Joe! But remember that it is important for most business owners to leverage their own cash by using other people’s money. First, if you wait to save the $100,000 on your own, your business might take years to get off the ground. Second, if you spend all of your own savings on the new business now, you might find it difficult later to get help from the bank
or Uncle Joe, at a point in time when you need cash. Avoid being undercapitalized: have enough cash on hand to handle all the rainy days.
The bottom line is that business owners should keep an eye on how their businesses are capitalized,and how well. It could mean all the difference between success and failure.