Let’s talk about finance.
Whether you’re looking to open a brewery, or something a little less capital intensive, you’re going to face the question of how to finance the venture. While it seems simple, it’s a puzzle many aspiring entrepreneurs can never fully resolve. According to Statistics Canada, about 85 per cent of new businesses survive for one year, 70 per cent survive for two years and 51 per cent survive for five years. The main reason for their failure? Undercapitalization.
What is Undercapitalization?
Undercapitalization is when a business has insufficient funding to continue operating. And, while capitalization can affect businesses of all sizes, it is particularly common and troublesome for small businesses. Even if the business in question appears to be running smoothly, hovering close to going into the red is a dangerous place for a business to operate in.
The Dangers of Undercapitalization
Undercapitalization acts as a powerful limiter of business growth. After all, how can you make the investments needed to achieve expansion when your cash flow operates on a month-to-month scale? Without sufficient cash on hand, businesses are vulnerable to seasonal sales swoons, the arrival of competitors on the scene, or wider financial shocks that affect the economy they operate in.
How Much Finance Does a Business Need?
The good news is, it’s not terribly difficult to establish how much finance a start-up business will need. All an entrepreneur needs to do is answer one overarching question: How much money will be needed to start and operate the business until the break-even point is reached – the point when sales revenue equals total expenses. To reach this answer, it helps to break it down into smaller chunks:
- How much money is required to get the doors open?
- How much of your own money do you have to contribute?
- Do you already own any of the assets needed to start the business?
- Will you need to buy assets? If so, which ones?
- Do you have any family, friends or others who are willing to invest?
- How is your personal credit rating?
- Do you have a line of credit available to use on the business?
The Types of Investment Available
Entrepreneurs have several options available to them when assessing how to fund their start-up business venture. Let’s briefly look at the most common…
In an equity investment arrangement, an investor makes funding available in exchange for an ownership slice of the business. It includes any money from individuals, including yourself, or other companies in your business. Be extremely careful with the amount of your company you’re willing to hand over in an equity arrangement. Anything more than 50 per cent and you’ve lost control of the business.
Returning to our friends at Statistics Canada, they found 76 per cent of small businesses in British Columbia had financed their business with personal savings. While this gives you ultimate control of your own destiny, it will leave a massive hole in your own personal finance. The healthiest place to be is to fund 25 to 50 per cent of the business through your own pocket. The rest can come from lenders or investors. This demonstrates that you have skin in the game and will be committed to the business’ future success.
Behind personal savings, debt financing from a financial institution account for the second most common type of financing at 44 per cent. Terms can range from long-term (usually for fixed assets you expect to use for more than one year) to short-term encompassing lines of credit or credit cards. These are often used to cover day-to-day expenses but are subject to higher base interest rates.
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