Thousands of new businesses launch every year in the form of restaurants, gas stations, retail outlets, tech startups, and more. This is despite the chilling 70 percent failure rate of new businesses on a ten-year timeline. Of course, failure is a generic term that can encompass a lot of factors.
Reasons for failure range from improper business models and poor marketing to products without a market. Yet, financial issues are some of the most common reasons for failure. The worst offender in terms of financial mistakes is under-capitalization.
Not familiar with under-capitalization? Keep reading for a quick overview of what it is, how to avoid it, and its major pitfall.
What is Under-Capitalization?
A very basic under-capitalization definition is that your business lacks sufficient money to operate and pay debts. This is unfortunately common in new businesses.
The main reason is that the owner or founder simply underestimated the startup and operating costs for their new business.
For example, they might have estimated office space and utility costs based on local averages only to discover that their actual costs ran 30 percent higher than that. Maybe they assumed they could run the business with five, full-time employees making $15/hour, but ended up paying closer to $20 per hour.
Individually, none of these will prove necessarily fatal, but add up enough extra costs and it’s easy for a business to run out of funds.
How to Avoid Under-Capitalization?
One of the best ways you can avoid undercapitalization is with an extremely in-depth business plan. Keep digging into the available information until you’re sure you’ve accounted for all the hidden costs that go along with launching a business in a given industry.
Don’t overspend. New entrepreneurs, especially ones who get outside investment, often overspend in their first year. Don’t rush expansion, hiring new employees, or upgrading your office equipment until you’re confident the numbers justify it.
The Major Pitfall of Under-Capitalization
Forming a corporation is one of the first things that business experts recommend you do when starting a business. When you create a corporation, even an LLC, one of the biggest benefits you get is shielding your personal assets from business-related lawsuits.
If your business suffered from under-capitalization, though, you risk a court piercing the corporate veil. In fact, undercapitalization is one of the major justifications for piercing the corporate veil.
When that happens, it exposes you personally to liability for the corporation’s debts or actions. That also exposes your personal assets.
Under-Capitalization and You
Under-capitalization is a serious problem. It can drive business failure and even expose you and your personal assets to risks. It’s also an avoidable problem in many cases.
Dig very deep when writing your business plan so that your numbers reflect all the costs, both hidden and obvious. This alone will go a long way to keeping you afloat. Keep spending down wherever possible until you can justify the new cost.
Looking for more business finance tips? Take a look at some of our other posts in our Finance section.