Capitalization of a Start-Up

Considerations on Generating Funding

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The word "capitalization" can have many meanings in small business. It could be, in accounting, where the cost of equipment is written off as depreciation over time. It could be the conversion of retained earnings into capital. It could be the conversion of a capital lease into a capital lease. Or, it could be punctuation rules when writing a business plan. Or more.

Capitalization of Your Start-Up

In this case we're referring to capitalization as generating money, or the funding that allows a business to open its doors.

It's also called funding, backing, investment and owner's stake.

Capitalizing your start-up can have long-term effects on your company’s success. Funding start-up expenses, inventory and operations is a challenge for many business owners. It's important to understand and explore the options are available to entrepreneurs, their risks and rewards, their plusses and minuses.

Capitalization is the first or seed money. It is the investment that the business owner and any other investors make in the firm. Combined with operating cash flows, it enables you to start, to continue and to grow by:

• Buying equipment, vehicles, R&D, etc.
• Funding growth by purchasing inventory, hiring employees, financing receivables, etc.
• Providing reserves for those inevitable rainy days.

Considerations

While this is a complex topic, let's go through some basics:

You've got to have a comprehensive business plan which is your educated, best-guess on the goals and objectives of your start-up, your target market, how you will get them to buy from you, how much money you need and when revenue will start to come in and how much.

When will your business turn cash-positive? When will you be able to pay back investors, whether they are outside investors, friends and family, or you. 

Assess your sources for funding. If you can fund this out of your own pocket, you retain complete control. A bank loan means monthly payments. Outside investors, such as angel investors (individuals who are wiling to invest in businesses with promise), private equity and venture capitalists will all want a piece of the business in return for their money.

Eyes open - they want a percent ownership of the business because they have their own set of goals that, to them, are more important than yours. If you are willing to pursue outside investors, it's likely that your business plan will have to show substantial growth within 3 - 5 years.

Equity and Debt Funding

It's important to understand that there are two types of capitalization: equity funding and debt funding.

Equity means ownership, which could be in stock or shares, partnership interests; or if an LLC, it is issued in the form of interests. The advantages of equity means there are no monthly payments and no one is looking for immediate repayment. Some of equity investors may even be experts in your field and be able to offer advice. The downside of equity is you are no longer in complete control, and in some cases, equity investors may be entitled to a portion of profits.

Debt is a loan issued to your company. The advantages are that you maintain control, and the regular timely repayment of the loan builds credit (and interest payments are deductible). The downside to debt is you've got to have the cash flow to meet the monthlies, it may be hard to borrow everything you need, many institutions will ask that you personally guarantee the loan, and if the debt is held by family and friends, and you eventually cannot repay, it may harm those relationships.

Work with your business mentors, your tax and accounting professionals to determine the capitalization plan that's best for you and your start-up.