Undercapitalization is a situation in which a business has insufficient funds, or capital, to support its operations. Although undercapitalization can affect any business, it is particularly common and problematic for small businesses. In fact, undercapitalization is one of the warning signs of major financial trouble for small businesses, as well as a significant cause of small business failures. Undercapitalization also acts to limit the growth of many small businesses, because without sufficient capital they cannot afford to make the investments necessary for expansion. In this way, undercapitalization can pose a problem even for profitable small businesses. "What separates the successful entrepreneur from the unsuccessful? In many cases, it seems to be whether the prospective business owner has access to sufficient funds," Brian Hamilton wrote in the Small Business Administration publication Financing for the Small Business. "Without sufficient capitalization, companies do not have the staying power to withstand intense competition or downturns in the business cycle," Richard Hamilton added in an article for Manitoba Business.
The amount of capitalization needed by a small business depends upon a number of factors. Businesses that offer a service usually require less funds than those that manufacture a product. Similarly, businesses in which the owners perform most of the work tend to need less up-front capital than those that must hire employees. A company's initial capitalization also depends on the entrepreneur's ability to invest personal funds and institute a sound business plan.
In order to avoid future problems with undercapitalization, entrepreneurs need to perform a realistic assessment of their expenses and financial needs. Some of the major expenses facing a new business include facility rental, equipment, supplies, utilities, insurance, advertising, business licenses, and salaries. Based upon this information, the entrepreneur should prepare a cash flow projection on a monthly basis for the first year. The difference between the funds the entrepreneur is able to contribute, the amount of income the business is expected to generate, and the amount of expenses the business is projected to incur provides a rough estimate of the business's financial needs. The entrepreneur must approach various sources for debt or equity financing to make up the difference and provide the business with sufficient capitalization.
Although more than 50 percent of small business failures can be attributed to undercapitalization, it is important for entrepreneurs not only to raise enough money but also to use that money wisely. In an article for Inc., Norm Brodsky noted that many entrepreneurs fall into an "image trap," trying to present an image of success with fancy offices, expensive but unnecessary equipment, and personal perquisites. Spending valuable funds on such luxury items is a sure invitation to business failure. Instead, Brodsky recommends that entrepreneurs put off such expenditures until the business is successful, and instead concentrate on making good decisions to build the business while making their capital last.
A little-known problem associated with undercapitalization is that it can increase the likelihood of the owners of a corporation being held personally liable for business-related matters. One of the main reasons that entrepreneurs choose the corporate form of business organization is to protect themselves against personal liability for business debts and court judgments. Incorporation does not afford automatic protection, however. Corporate owners can be held personally liable in a number of situations, including cases where personal and corporate assets are commingled, the corporation does not keep adequate records, or corporate owners intentionally defraud their creditors.
But perhaps the most critical factor in determining whether there should be personal liability for corporate debts is whether the owners provided sufficient capitalization for the business. "This issue is so important that owners risk personal liability even if it is the only factor a court finds," according to Nation's Business contributor Anthony J. Mohr. "The ultimate test is whether there are enough corporate assets to satisfy corporate obligations." For example, an entrepreneur could not contribute only $500 to start a new business, knowing that it actually required an initial capital outlay of $10,000, and expect his or her personal assets to be protected in case the business became insolvent. In this instance, a court would be likely to rule that the extreme undercapitalization of the corporation made the owner personally liable for its debts.
Brodsky, Norm. "Why Start-Ups Fail." Inc. December 1995.
Ellison, Mitch, and Neil E. Seitz. Capital Budgeting and Long-Term Financing Decisions. HBJ, 1999.
Hamilton, Brian. Financing for the Small Business. Washington, DC: Small Business Administration, 1990.
Hamilton, Richard. "Will Your Company Survive?" Manitoba Business. May 1996.
Mohr, Anthony J. "Take Care to Avoid Liability Traps." Nation's Business. November 1997.