One of the leading reasons that new businesses fail is because they run out of sufficient capital to continue operating.
Capital, in the business world, refers to the assets a business accumulates over time that it uses to continue its operations.
Regardless of whether you are running a business that sells products, or a business that provides services, it is imperative that your business always maintain sufficient capital.
In this video, we discuss:
- What capital is
- Why it is important to have enough capital
- What can happen if a business does not have enough capital
- Different types of capital
- How to raise capital
What capital is
It is commonly believed that capital consists only of the money in the bank accounts of a business. Depending on who you ask, that might be true.
Others will say that, in the business world, capital includes more than just money in the bank. Capital can also include items such as:
- Revolving credit
- Lines of credit
Well-trained and skilled employees are sometimes considered to be “human capital.”
What all of these items have in common is that they are assets used by businesses to operate.
We will stick mainly to the common understanding of capital as referring only to financial assets, such as deposit accounts. But, at times, we will also talk about other types of capital.
Why it is important to have enough capital
Capital allows business operations to remain stable and to continue without interruption. Further, having enough capital allows businesses to grow and expand into new markets.
Businesses use capital for different purposes, such as:
- Paying for everyday, ongoing expenses
- Purchasing new equipment and maintaining existing equipment
- Expanding operations into new locations
- Acquiring operations from other businesses
What can happen if a business does not have enough capital
Not having enough starting capital, or running out of capital after operations have already commenced, can mean an early death for a business.
It is not uncommon for new entrepreneurs to underestimate the amount of money they need to get their business up and running. New entrepreneurs also tend to inaccurately forecast the amount of time it will take to begin making sales and bringing in the revenue necessary for sustaining their business.
Also, new entrepreneurs oftentimes run into the pitfall of not having enough cash on hand to weather unplanned events, such as loss of or damage to inventory, or an involuntary closure of their business.
Running out of working capital, or money needed to pay current debts or liabilities, can result in a cascade of negative consequences for a business:
- Bills stop being paid, so vendors and suppliers end their relationships with the business.
- Since vendors and suppliers have ended their relationships with the business, it is difficult or impossible for the business to stock inventory needed to fill customer orders.
- Since customer orders are not being filled, customers are taking their business elsewhere.
- Since customers have taken their business elsewhere, sales revenue can no longer cover operating expenses.
Ultimately, running out of working capital will lead to the demise of the business.
Different types of capital
Now that it is clear the undesirable sequence of events that can happen if a business does not have enough capital, let us talk about the different types of capital and how they can be acquired.
Financial capital is typically broken down into two categories:
- Equity capital
- Debt capital
Equity capital refers to the investment of cash into a business by the owner of a business and also by outside investors. In return for the contribution made by the outside investor, the investor receives an ownership stake in the business, known as equity.
The primary benefit of equity capital is that the owner of the business does not guarantee that the investment will be repaid. However, that does not mean the business owner is free to spend the investment money as they please.
When a business owner receives money from an outside investor, the business owner owes a fiduciary duty to the investor. This means that the business owner must use the investment money in a way that benefits the business.
The upside for an investor making an equity capital investment is that if the business is a success, the investor can realize an unlimited return on investment, or ROI. Compare this with debt capital, which we discuss later, where the investor receives a fixed return on investment in the form of interest.
To illustrate why an investor would want to contribute cash into a business in return for equity:
According to a Forbes article, in 2012, Australian investor Jeremy Liew contributed $485,000 to Snap, the company that owns the social media app, Snapchat. Five years later, that investment made by Liew was worth about $2.5 billion.
The downside for a business owner financing their business with equity capital is that equity capital can be quite costly:
Liew, in return for his $485,000 investment in Snap, received an 8.6% equity stake in Snap. Only the founders of Snap, Evan Spiegel and Bobby Murphy, owned more of Snap than Liew.
Although Liew received a substantial windfall from his investment in Snap, there was also the possibility that his investment would become completely worthless.
Investors contributing capital to a business in return for equity expect to be rewarded for the risk that they are taking.
If a business owner wants to obtain capital without giving up any ownership stake in their business, then the business owner should look to debt capital.
Debt capital, in contrast to equity capital, does not require a business owner to give up any ownership stake in their business. Investors who provide capital in the form of debt, meaning that they are loaning money to the business or extending credit to the business, are repaid in the form of interest. Interest is an amount paid to the investor in return for the loan or credit they extend, typically specified as an annual percentage rate, or APR.
Unlike with equity capital, when a business owner receives debt capital from an investor, the business owner is guaranteeing that the money will be repaid. If the money is not repaid, then the investor can file a lawsuit or take other action to get their money back.
Many times, when an investor makes a loan to a business or extends credit to a business, the investor takes a security interest in assets belonging to the business. When an investor takes a security interest in the assets of a business, the investor acquires the right to take possession of and sell the business assets if the business fails to make its payments.
Security interests act as assurances to an investor that their loan or extension of credit will be repaid.
The upside for investors who contribute debt capital is that they are guaranteed a return on their investment.
The downside for investors is that, even though the business guarantees payment on the investor, repayment is not truly guaranteed.
If the business is performing poorly, the debt capital investor might have to renegotiate terms with the business owner. For example, the interest rate might have to be reduced. Or, payments might have to continue for longer than originally contemplated.
If the business is performing very poorly, or fails entirely and files for bankruptcy, the debt capital investor might only receive back a portion of their investment, or possibly nothing at all.
The luxury retailer Neiman Marcus, for example, filed for bankruptcy in 2020. According to Bloomberg, as part of its bankruptcy, Neiman Marcus will give up control of its department stores in return for a reduction of its debt obligations from about $5.5 billion to $1.5 billion.
Every business is unique and business owners need to decide for themselves what type of capital is best for their business: equity capital, debt capital, or a mixture of both.
Once the decision has been made, the business owner needs to actually raise capital.
How to raise capital
Raising capital is, admittedly, not a simple task, especially for new and small businesses. Investors face a greater risk investing in new and small businesses than they do with businesses having an established history of providing a return on investment.
Still, there are a variety of ways new and small businesses can obtain equity and debt capital. Here are a few examples:
Self-funding, sometimes known as bootstrapping, refers to funding of a business by the business owner themselves.
When a business owner bootstraps their business, they have complete control over how the business operates. They are free to run the business as they please.
Further, when a business owner bootstraps their business, they alone enjoy all of the profits and rewards of having a successful business.
Business owners who have bootstrapped their business should be highly motivated to lead their business to success. They have skin in the game, meaning that they lose their investment should the business not work out.
In order to bootstrap their business, business owners might need to:
- Obtain a personal line of credit from their bank
- Put business expenses on personal credit cards
- Work a part-time job or do freelance work to earn extra money
Self-funding, or bootstrapping, should always be the first choice for raising business capital, as it does not obligate the business owner to others.
Government grants and loans
Business owners should search for government grants and loans available to raise capital for their business.
As an example of a government grant program:
In response to the COVID-19 pandemic, the City of Los Angeles and County of Los Angeles, together with various philanthropists, established the LA Regional COVID-19 Recovery Fund.
As part of the LA Regional COVID-19 Recovery Fund program, grants were given out to businesses of all sizes, from micro-entrepreneurs, to small businesses making between $1 million and $5 million.
Although the LA Regional COVID-19 Recovery Fund program is no longer giving out grants, it will be offering flexible loans to micro-entrepreneurs and small businesses.
Government grants and loans are an attractive source of capital for business owners:
- Grants do not have to be repaid, and they do not require business owners to give up any equity in their business.
- Loans typically have below-market interest rates and can sometimes be forgivable, meaning the business owner does not have to repay the loan if the business is not working out.
Capital through crowdfunding might be available, depending on the type of business being operated.
With crowdfunding, customers pool their money together and invest that money into a startup business. The startup uses that investment as capital to begin developing and producing a product. In return for their investment, the customers receive the product once it is completed.
Crowdfunding is viewed as being an alternative type of capital, since it does not require a business owner to give up equity or pay back a loan. Rather, the business owner becomes obligated to develop, produce, and deliver a finished product to the investor-customers.
Friends and family
Finally, and arguably the least desirable way of raising capital, is soliciting investments from friends and family.
The benefit of looking to friends and family for capital is that it is more likely to be obtained than from other sources of capital. Moreover, the investment terms will probably be better than the terms outside investors are willing to offer.
Friends and family know you better than outside investors and financial institutions ever will. They know your particular set of skills, your work ethic, and your ability to accomplish goals.
The investments that friends and family are willing to make into your business can be based on your reputation and credibility, rather than on just your finances.
Although soliciting investments from friends and family might sound like an attractive way of obtaining capital, the capital comes at a very heavy price: should the business not work out, important, meaningful, long-lasting relationships can be destroyed.
In this video, we have gone over what capital is, why it is important to businesses, and how it can be raised. This knowledge can be used by business owners to make sure their business has the capital, and uses the capital, needed to make their business a success.