The day has come for the doors of your business to open. The paint is fresh on the walls, the business cards are professionally printed and the widgets are ready to be sold. There is a little money left in the bank but not enough to cover the rent for next month or payroll.
This means that the business is officially undercapitalized.
Undercapitalization means a business does not have and cannot obtain the funds required through equity or debt for current operational expenses or to pay creditors. With little money remaining to cover the operational costs, the business is exposed to risk and potentially bankruptcy.
Regardless of whether the business is small, startup or traded on the stock exchange, any business can be undercapitalized. But startup and small businesses are the most commonly undercapitalized entities. While service-type businesses do not typically need as much operating capital as manufacturing type business, both need to be adequately funded.
Lack of proper financing initially: Upon the initial formation of the business there may not have been sufficient funds due to any number of reasons. But the decision was made to open the business anyway. Whether you were depending on loans, an investor, or sales to make a difference, the bottom line is more money is needed in order to make ends meet.
Lack of access to bank financing: Frequently small businesses seek financing from the bank when their back is up against the wall and this is a last resort. This rarely results in a bank loan since the best time to seek funding is when the business is fully capitalized. Acquiring a bank loan when you need one is a rare occurrence. The bank usually seeks to limit its liability and exposure to risk. They accomplish this feat by offering loans only to those that have proven that they can pay the money back or that have significant assets that can be utilized to pay the loan back in the event of default.
Financials depicting a loss or limited income: Accountants are typically engaged to limit the taxes owed to Internal Revenue Service by minimizing profit with the use of legal deductions. But the corresponding impact to lower revenues and taxes is that it is now difficult to obtain traditional financing with the lower income depicted. So you may save on one hand but lose on the other hand.
Failure to obtain insurance: These days there is an insurance policy to cover most situations. When the business is not properly insured, the owner is at a major risk of being undercapitalized if forced to cover the losses from the operating income.
Financing: Short versus long term
Unfortunately when an undercapitalized small business needs operating capital, it does not have the luxury of choosing debt versus equity. It usually has to choose the first available which tends to be short-term loans, which have to be paid quickly at an outrageous interest rate. Short-term loans exacerbate the lack of capital situation and results in placing a temporary patch on a bad situation.
How to overcome Undercapitalization
Prompt Invoicing: Since cash flow is the backbone of all businesses, issuance of a prompt invoice is mandatory. The sooner a client receives the invoice with the associated payment terms, the quicker the business can receive payment and the infusion of cash into the business.
Collecting overdue receivables: Mechanisms must be put in place to pursue overdue receivables. Once the invoice has been issued, if the customer fails to pay promptly the business must pursue payment. It is inevitable that there will be some losses. However, there will also be some gains.
Renegotiating lower interest rates: If you have debt in place currently, negotiating with lenders for a lower interest rate would be beneficial. Many lenders may not be willing to renegotiate but some may. But it still may be worth a try.
Factoring accounts receivables: Sometimes businesses have accounts receivables from very reputable agencies with longer length of payment terms. In this situation it may be advantageous to use a factoring company to obtain the money from the accounts receivables now rather than later. The factoring company will usually charge a few percentage points of the outstanding invoice and will also serve as the collection agency for the debt. The most important point to remember is to make sure that there is enough profit from the invoice to pay the factoring company so that money is not lost on the transaction.
Equity financing: By bringing in an additional investor, the business can experience an influx of funds without the immediate need to repay. Through the use of personally known investors, private placement, or venture capital funds, the business can pursue much needed capital.