How Does Capital Intensity Impact Small Business?
Small businesses come in all sizes. Whether it’s a micro business or a regional franchise, most entrepreneurs understand that starting a company can be a complex endeavor with multiple barriers to success. One of the most common obstacles for businesses regardless of size is access to financial capital, but this can be especially difficult for an enterprise that is capital intensive.
What does capital intensive mean?
Companies that require a large amount of upfront financing to purchase the assets and supplies necessary to start their enterprise are generally called capital-intensive businesses. They are traditionally involved in industries where the cost of labor is relatively low compared to the funding necessary to produce a specific good or service.
However, a capital to labor ratio isn’t the best indicator to determine whether a business is capital intensive. Instead, the standard formula used to earn this label is a ratio that measures the amount of money invested to produce a good or service to generate one dollar of sales revenue. In simpler terms, it is your Total Assets divided by your Sales Revenue.
Capital Intensity Ratio = Total Assets / Sales Revenue
A by-product of the Industrial Revolution, when major investors for machinery and infrastructure buy-in were a necessity for new companies to build large factories, warehouses and transportation hubs, capital intensity quickly became an economic component of traditional business practices that all entrepreneurs studied regardless of how small their venture may be. It didn’t take long for industries like high-volume interstate shipping, telecommunications or steelworks manufacturing to begin to affect small business owners as much as their larger counterparts.
Does capital intensity exclude small businesses?
Many have argued that capital-intensive industries aren’t customarily small business-friendly, but it all may be a matter of perspective. During the late 19th century, capital-intensive companies increased productivity in ways labor-intensive businesses could not, and therefore, distribution and consumption of products and services expanded exponentially. Small businesses reacted to this change by creating niches that capital-intensive enterprises overlooked, or by adapting their smaller operations to complement the bigger fish.
How can small business owners build a capital-intensive startup?
If you’re an entrepreneur interested in becoming one of the bigger fish and not just a complement to their enterprises, the barriers of entry to capital-intensive industries are considerably high. While securing investors for a new box subscription service or app development idea can be grueling enough, finding investors willing to provide funding for chemical manufacturing or an interstate shipping company is a far more difficult task.
Here’s how you can get your foot in the capital-intensive door:
1. Build a Strong Financial Model with Your Plan
For those who are determined to be the next Netflix to their industry’s Blockbuster Video, there are ways to build a capital-intensive startup through proper budgeting and planning. The operative word here is planning. Most entrepreneurs are aware of the importance of a solid business plan, but for a capital-intensive startup, the business plan also needs to include a comprehensive financial model explaining how and when you will achieve profitability.
Analyze the industry’s economies of scale, equipment depreciation rates, and profit margin ratio, then incorporate these details into the financial modeling for your business plan. Research is your best tool in building a strong model and plan for your capital-intensive venture.
2. Seek Investors Wisely
The next step is to secure investors based on your business plan. An effective strategy to startup funding is to utilize a mix of personal investment dollars, business loans, and capital investors. However, be mindful of how you structure your investor agreements. If you rely too much on capital investors, the question of equity will leave you feeling as if you’re working for someone else instead of running your own business. Try to structure it so your agreements allow equity, but limit the amount or type of input your investors are allowed to provide.
3. Investigate a Variety of Grants and Loans
Loans are a reality of capital-intensive businesses, but there are options to tailor them to your company and reduce the weight of private loan interest rates. If your venture is one that will help provide for a greater good or a social need, you may qualify for a grant or low-interest loan. The Small Business Administration will likely have a list of industry-specific loans for your enterprise that lend money at a much lower rate than their private counterparts.
Due to the nature of capital-intensive industries requiring more financing than most labor-intensive industries, a combination of grants, low-interest and standard interest loans may be necessary to get your startup off the ground.
4. Remember to Deduct
After you have all your financing in place and your business is up and running, be sure to deduct as many capital expenses as possible in your first year. Deducting your expenses (as opposed to capitalizing on them) allows you to take advantage of a lower tax liability during your first year of operation.
For equipment-heavy industries like fiber optics, shipping or construction, a low-tax liability can make a big difference in how quickly you achieve profitability. After your initial year in business, you can choose to capitalize on your expenses instead, but for that first year, remember to deduct only.
How does capital intensity impact small business?
Capital intensity impacts small business owners on multiple levels. And although they may seem to exclude the single entrepreneur from the corporate round table, it is possible to create a capital-intensive business in our tech heavy, post-industrial economies. Many investors seek out capital-intensive businesses because of the potentially high ROI they can deliver, and industry disruptors are always in fashion.
Whether your startup is micro-sized or you’re an entrepreneur breaking into an industry with a high barrier of entry, capital intensity has an impact on all small business owners, but only you can decide if that impact is beneficial or otherwise.