Businesses need capital to grow. Besides what you invest, capital can come from profits you leave in the business, from investors or partners who put money into the business, or from money you borrow. This last source has some use and repayment constraints, which must be met in order to really be capital.
To keep it simple, money borrowed which doesn't have to be repaid for several years and which can be used for any legitimate business purpose can be part of the business’ capitalization. An installment loan, say to finance a truck, or a mortgage to help with the purchase of a building does not count.
A good way to think of capital is to compare it to the horsepower of an engine. Small engines with minimum horsepower have to strain to handle the slightest problem. They tend to wear out quickly and often need lots of care as they go about their work. Big engines with lots of horsepower almost loaf through normal use; they have plenty of reserve power to take advantage of the opportunities a wide, clear road offers and to get around or over unforeseen difficulties.
The biggest mistake a new entrepreneur makes is failing to understand what the documents for a loan or the sale of a portion of the business really mean. For example, if you accept a line of credit from a bank the documents will usually require that you pay off any outstanding draws against the line once each year (usually the anniversary date. ) This could be a real problem if it occurs at a time when you are short of cash and also have plans for an expansion of the business. Banks are willing to work with their customers in such situations, but their new terms might be a lot more onerous.
The documents will probably state that the bank will file a lien on everything the business owns. This lien goes on top of any vehicle installment loans or mortgages on real property. In legal terms, it goes in second, or a third or whatever is next - position. This also includes the business’ accounts receivable. Many businesses don't realize that they have no credit capacity left after they take a line of credit. That's right, they can't arrange financing using their accounts receivable, without going back to the bank that provided the credit line and renegotiating.
An investor in your business may also place restrictions on what you can do. The documents covering the investment could make it difficult and expensive for you to bring in another investor. One way this is done is through a non-dilution clause.
Here's how it works. Suppose you own 100% of the business (all the shares of a corporation), and you make a deal with an investor that gives him half the business. His money goes into the checking account and the corporation issues him the same number of shares that you have. You and he are now equal partners. If his investment provides that his position cannot be diluted then the only way the business can bring in another investor is to issue the first person free shares so he will always have fifty percent ownership. Guess whose ownership percentage gets reduced - that’s right, yours!
Whenever I took in an investor, I always made sure I had an option to buy him out.
The successful entrepreneur quickly learns that the key to growing a business is to be certain there are options to raising capital and that the options have as little cost as possible.
I recently helped the owners negotiate a substantial investment for a minority ownership position in their company. They were five engineers (the high-tech type) who had little business experience. They had started their business in a Sub S Corp, which is a poor structure to bring in new capital and additional investors. I suggested they form a regular C Corp. They did and they also started taking steps to transfer all their patents to the new company. I suggested that they keep the patents in the Sub S Corp. I reasoned that if they licensed the use of the patents to the C Corp, the investor would probably be happy. I offered the possibility that later, if the C Corp was doing really well the Sub S Corp could sell the patents to the C Corp and the engineers would then get additional cash part of which would have been paid by the investor as his share of the ownership of the C Corp.
Art Consoli held eight corporate positions with Johnson & Johnson before starting his first business. He went on to build over twenty businesses from patents or ideas or from businesses others couldn't make successful. These ranged from starting a veterinarian drug company to taking over a steel fabricating company to developing the first manufactured home subdivision to qualify for every private and government assisted mortgage program in Arizona. He also did ten workouts for lenders and owners; the last was a $30 million, 300 employee, precision parts manufacturing plant that made parts for the auto industry. Consoli's unique background and skills allow him to speak and write about how someone with limited experience can do a self-evaluation which will let him decide which business opportunity is best, how to evaluate opportunities and gain control over the one which offers the greatest potential and then manage that business to success. Readers of his book call and write to tell him how much his book has helped their lives and improved their business.