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It may seem like only yesterday when you liquidated your children's college funds, took out a second mortgage or borrowed money from your in-laws to get your hardwood flooring contracting business started. But capitalizing a company doesn't just happen in the beginning. Every company, new ones and existing ones, must deal with capitalizing issues—particularly the successful ones, because success begets growth, and growth requires capital. If your company needs capital, as the owner, you are the one who has to get it.
Webster's dictionary defines capital as any asset, tangible or intangible, that is held for long-term investment. Capital, blended with cashflow, is the financial fuel your company's engine uses to, among other things:
• Invest in equipment, vehicles, etc.
• Fund growth by purchasing inventory, hiring employees, financing receivables, etc.
• Provide reserves for those inevitable rainy days.
Three Kinds of Capital
1. Investment Capital. This capital comes from you or someone else. It's like buying stock in the stock market except for one thing: When you make an investment in a small, closely held corporation, there is no market for your shares. Therefore, you typically won't get your invested capital out until you sell or otherwise dissolve the company. Consequently, most small businesses have only a nominal amount of shareholder capital—typically from $1,000 to $10,000—and this investment will usually be made only at the point of incorporation.
2. Retained Earnings. These are the profits your company has made that are left to accumulate in the company—in other words, the profits you didn't take out as a salary, bonus, dividend or other distribution. Of all the forms of capital your company could have, this is the best kind, because you got it the old fashioned way—your company earned it.
Your banker likes seeing retained earnings on your balance sheet even more than equity capital because it says two things: a) your company had the ability to produce retained earnings by operating profitably; b) as the owner, you had the discipline to leave this capital in the company instead of distributing it.
3. Borrowed Funds This is plain old debt—money you borrow from a bank or an individual. Debt can be an excellent way to capitalize your company. But there is one annoying little detail about borrowed money: Unlike investment capital or retained earnings, debt accrues interest and requires debt service—payments—which creates an incremental drain on your company's liquidity.
Your business needs to generate the cash flow to make these payments. If it can't, you shouldn't be asking for the loan. You should know if you can service the debt before you get to the bank with your request.
One of the individuals your company could borrow from is you, the owner. Instead of investing your money in your business as investment capital, you could lend it to your company. Unlike equity capital, which stays with the stock and only pays a return if you declare dividends (a rare event in small businesses), a loan from you to your company produces a return through interest payments, which are made by your company.
You could loan money to your company as a personal income strategy. If your company needs money and you have it, why let a bank earn the interest? Plus, since you are essentially the bank, the approval process is very short. For specifics, consult with your CPA.
Holding On
In my opinion, the way to wealth and independence for the average person in America who wasn't born with it is through the accumulation of equity, not the earning of personal income.
If you are an employee of someone else's company, all of your compensation from your efforts comes in the form of earned income, and it is reported on your W-2 form. Yes, many companies do offer stock options. While this practice seems to be increasing, employees who have this opportunity are still in the minority nationwide.
As a business owner, you receive a W-2 for the salary and bonus you take. But all of your financial benefit doesn't have to be earned income. You have the opportunity to leave some of the company's earnings in the company in the form of retained earnings, which becomes equity—your equity. Some of this equity will be in the form of cash, but most of it will be in inventory, equipment, fixtures, vehicles, real estate, added business value through market penetration and brand development, etc.
As long as you are in business, every dollar of retained earnings capital is making you money. Retained earnings is:
• the working capital that you don't have to borrow from the bank or dilute your ownership with by taking in other investors' capital.
• your safety net during the inevitable period(s) of slow sales or other problems that can befall a small business.
• your financial home run when you sell your business.
Involvement or Commitment?
Another reason to maximize retained earnings in your company is that bankers like to see a large retained earnings number on the balance sheet of a company they are considering for a loan. A history of retained earnings in a company says commitment, and bankers like borrowers to be committed in their business, not just involved. Do you know the difference between involvement and commitment? When you look at a plate of bacon and eggs, you can see that the chicken was involved in your breakfast, while the pig made more of a commitment.
The Smart Money
If you want to demonstrate that you practice sound management fundamentals, leave every nickel you can in your business. Think of it as paying your business first. By taking care of your business now, it will take care of you later.
So, if retained earnings are so great, why would anyone ever invest money or borrow to capitalize a company? Unfortunately for most businesses, accumulating working capital through retained earnings is a slow process. In today's marketplace, most businesses need working capital to fund growth faster than their profits can generate retained earnings.
The best plan is to incorporate all three methods of capitalization. It's really very simple: Leave every cent of earnings that you can in your company, and invest and/or borrow the balance of what you need to grow your business.
If you want to own your company outright one day—with no debt—you will have to begin a disciplined, longterm process of accumulating retained earnings. By amortizing your debt, you will be replacing debt capital with retained earnings capital. As I said earlier, talk with your CPA about the best combination of capital options for you.
Write this on a rock ... Understanding the benefits of accumulating retained earnings is one of the most critical perspectives a small business owner can acquire. Don't get discouraged. It is a long-term process, but it's worth it.