The word "capitalization" can have many meanings in small business. It's used in accounting to describe the cost of equipment that's written off as depreciation over time. It also describes the conversion of retained earnings into capital and the conversion of an operating lease into a capital lease.
In this case, though, capitalization refers to generating the money that allows a business to open its doors. It's also called funding, backing, capital investment, and owner's stake.
How you capitalize 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 available to entrepreneurs, along with each method's risks and rewards.
Capitalizing Your Startup
Capitalization is the initial investment or seed money for a start-up, and it's usually the investment that the business owner and any other investors make in the firm. Combined with operating cash flows, it enables you to start, continue operations and grow the firm by:
- Paying for assets such as equipment, vehicles, and real estate
- Funding growth by purchasing inventory, hiring employees, financing receivables, and more
- Providing reserves for the inevitable rainy days
Capitalization can include both equity and debt, although companies typically prefer to keep debt to a minimum.
Finding the Money
Start with a comprehensive business plan that contains your educated, best-guess on the goals and objectives of your start-up, your target market, how you will get customers to buy from you, how much money you need, when revenue will start to come in, and how much.
Model out financial scenarios to estimate when your business will turn cash-positive, and subsequently, when will you be able to pay back your investors, whether they're outside investors, friends and family, or yourself.
Assess your sources for funding. If you can fund the venture out of your own pocket, you retain complete control. A bank loan means monthly payments, debt covenants, and interest expense. Outside investors, such as angel investors, who are individuals willing to invest in startups with promise, private equity groups, and venture capitalists all want equity in the business in exchange for their money.
These investors want a percent ownership of the business because they have their own financial goals that, to them, are more important than yours. If you want to pursue outside investors, it's likely that your business plan will have to show substantial growth within three to five years so that you can offer these types of investors an exit strategy.
Equity and Debt Funding
Two types of capitalization exist, called equity funding and debt funding. Work with business mentors and your tax and accounting professionals to determine the right mix of equity and debt capitalization that makes sense for you and your startup.
Equity means ownership, which could be in stock or shares, partnership interests; or if an LLC, equity is issued in the form of interests. The advantages of equity include no monthly payments and no one looking for immediate repayment of their investment.
Some equity investors may even be experts in your field and be able to offer useful business advice. The downside of equity is you are no longer in complete control of your business because you've given a certain proportion of your ownership equity in exchange for funds. In some cases, equity investors may also be entitled to a portion of profits.
Debt is a loan issued to your company. The advantages include allowing you to maintain ownership control, and the regular timely repayment of the loan builds business credit. Additionally, you can deduct interest payments on your business income tax return.