Small Business Series – Mistake 3:
A third mistake that we see small businesses make is in regard to their equity. Equity, or capital, is the amount in which a business’ assets exceed its liabilities. It is a common component of many covenants that lenders apply to business loans, including tangible net worth and debt to equity. Because of the health of the economy, business earnings are the most common source of capital, according to the most recent NSBA economic report. While this is a good situation to be in, it does not absolve business owners and executives of the need to plan for future capital.
When businesses are in their very early stages, capital is one of the main focuses of entrepreneurs. Determining where to get the startup money is one of the biggest hurdles in starting a business, so many owners have some degree of a capitalization plan at the outset, whether it’s from money that is in savings, from a loan, from a family member, from an outside investor, or from the sale of personal assets.
As the business gets underway, owners have a good idea about where they want the business to go, so they generally know how much money they need to make in order to achieve their next goal, be it new machinery, a broader workforce, or investment in research and development.
Where we often see companies run into trouble in regard to capitalization is when the business becomes established. A lot of business owners begin their enterprise because they have an idea to do something better or improve upon an existing product. However, the driving force to starting a business is often to provide for family, retirement, and employees. Without a clear profit incentive, an idea is really just a hobby, so it is understandable that the business owner, who often has the most at risk in the company, wants a good return on investment.
Risks of thin capitalization
All too common, however, is the tale of the business owner that takes a disproportionately high percentage of earnings out of the company. Not only do tax ramifications come into play (such as, if there is inadequate basis for distributions, among others,) but the everyday risks of this aggressiveness are obvious: the business may not be able to progress because of a lack of equity, or it may also be susceptible to an economic downturn.
In the last recession, about 10 years ago, the businesses that we saw survive were the ones that did a good job of retaining equity in the years leading up to the recession. Those that ended up having to close their doors often did so because of overly thin capitalization.
To avoid the worst-case scenario of a forced closing of a business, owners must have a capitalization plan that continues through the life of the business, beyond just the first few years when equity may be more scarce. A sample plan may be that the business is going to retain a set percentage of the yearly earnings, give a percent to the employee pool, and distribute the remaining amount to owners. However, in a down year, the company may need to retain more than it earned, which would require a capital infusion by the owners. The company may also want a retention floor, the minimum amount that equity needs to increase in a given year, regardless of profitability.
The amount of capital to retain is based largely on the goals and needs of a business. A manufacturer, for instance, will probably need to retain a large portion of its profits because of the machinery and technological upgrades that are constantly needed. A construction company can probably afford to retain less equity if it relies on subcontractors to do much of the work and has fewer capital needs itself, although the size of upcoming projects should also be a determining factor in equity retention. A service business, like a law firm or consultant, can often take nearly all of the profits out of the business because the necessary assets are typically intangible, such as knowledge and experience.
Remeasurement and metrics
Businesses need to reevaluate their capital needs on a frequent basis. Using financial metrics are a good way to determine the health of the company’s equity. Looking at short- and long-term trends of return on equity, dividend payout ratio, and debt-to-equity will allow owners to see if their goals are conducive to maintaining a healthy balance sheet.
See previous installments in the Small Business Mistakes Series:
- Confusing Knowing a Trade with Knowing a Business
- Forgetting ‘Achievable’ When Setting SMART Goals for a Small Business