Undercapitalization

Undercapitalization refers to any situation where a business owner cannot acquire the funds they need. Usually, this refers to a business that cannot afford current operational expenses due to a lack of capital, which can trigger bankruptcy.

Overview

Undercapitalization is typically a result of improper financial planning. This is frequently due to human error, rather than economic conditions. Companies such as American Express, the Business Group, and Y.P.O. have made an industry out of foreseeing the causes of undercapitalization, and provide their services to businesses, for a fee. While this has proved to be an effective solution for some businesses, it is often seen as insufficient for companies who already have undercapitalization problems.

There are several different causes of undercapitalization (Levinson 1998). The main causes include:

• Financing growth with short-term capital, rather than permanent capital.

• Failure to secure an adequate bank loan at a critical time.

Financing growth with short-term capital

Business owners, especially small-business owners, frequently finance growth in a manner that lends itself towards undercapitalization. Growth is best financed through permanent capital. Examples of permanent capital include additional mortgages, outside investors, and term loans from banking institutions. Contrast this with short-term capital, such as revolving lines of credit, credit cards, and factoring accounts received.

An example of undercapitalization caused by growth financed with short-term capital can be seen in the 1998 failure of a popular graphic design business in Oakland, California. After its popularity warranted expansion, the owner applied for a bank loan, but failed to get it. The owner decided to finance her business growth using low-interest offers on various low interest credit cards, i.e. short term capital. During a summer lull, several late payments triggered a massive interest rate increase. Despite her growing and profitable business, this huge increase in the cost of capital forced her to declare bankruptcy.

Acquiring capital incurs costs. These costs can fuel long-term undercapitalization.

Capital sources

Here is a ranking of several capital sources from the least to the most expensive (Van Horn 2002):

• Finance from cash flow
• Regular invoicing
• Collecting overdue receivables
• Stretching payables without incurring interest or penalties
• Renegotiating existing loans for lower rates and larger balances
• Secured loans
• Personal savings
• Unsecured loans
• Failing to take trade discounts
• Using credit cards, cash advances
• Stretching payables while incurring interest or penalties
• Factoring accounts receivable
• Additional investments from existing partners or stockholders
• Private placement capital
• Venture capital
• Taking on a partner who makes a financial investment
• Taking on a partner who makes a “sweat equity” investment
• Not acquiring capital, and missing out on opportunity.

Failing to Secure an Adequate Bank Loan

A manual on collecting capital, by CPA David Levinson, states that one solid approach to assuring capital is to establish a line of credit, borrow against it, even if it isn’t needed, then pay back this loan. Doing this repeatedly can help a business owner expand their capital when they need to increase their credit or take out a larger loan (Levinson 1998).

CPA’s can structure the financials in order to minimize profit, and thus taxes. As a business grows, this approach becomes counterproductive (Van Horn 2006). Frequently, a growing business will apply for a bank loan only to find their entire accounting system under review. In 2001, a rapidly-growing I.T. company landed a substantial contract with a large-cap business. The I.T. company applied to its bank for an additional $500,000 on top of its current $250,000 line of credit. The bank refused and even called the $250,000 loan. The company CPA had structured the financials to never show a profit, even though the business was in the process of expanding tenfold.

References

• Van Horn, Mike (2002). How To Grow Your Business without Driving Yourself Crazy. San Rafael: The Business Group.
• Levinson, David (1998). Increase Your Cash Flow. San Francisco: T.B.G. Publishers
• Van Horn, Mike (2006) Build a Culture of Profitability Oakland: The Encounter Collaborative

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