What Is Initial Capitalization?

Mike Watson/moodboard/Getty Images

Every startup business begins with zero cash revenue coming in and a lot of money going out. Equipment must be bought, and licenses and permits must be paid. A few employees will probably need to be hired and paid.

Even after the business gets up and running, cash flow will probably be negative for the first months and maybe up to a year. The company will need enough money to pay all these startup expenses and fund negative cash flows to avoid closing its doors before ever making a profit. This is the minimum startup capital that a business will need to get through the early stages of growth.

The first step is to estimate how much money you will need and when it will be needed. The next step is to figure out how to finance the startup costs and negative cash flow. Will it be equity or debt?

TL;DR (Too Long; Didn't Read)

Initial capital is the funding needed to start a new business.

Estimate the Initial Capital Required

Every business is unique and has its own set of startup expenses. Consider the following example of the capitalization required to open a new restaurant:

  • Security deposit for rent: one month at $10,000
  • Rent for first month: $10,000
  • Utilities for first month: $2,000
  • Tables and furniture: $45,000
  • Tableware, dishes, utensils, kitchen and bar equipment: $90,000
  • Initial inventory of food and beverages: $10,000
  • Construction costs for serving area and kitchen: $300,000
  • Insurance: $8,000
  • Licenses and permits: $7,000
  • Signage: $20,000
  • Menus: $3,000
  • Coupons/ads/fliers: $10,000
  • Public relations promotion service: $9,000
  • Grand opening expenses: $18,000

Grand total: $542,000

Estimate Negative Cash Flows

During the early months of a startup, monthly cash flows will likely be negative. The initial capitalization must be enough for the business to fund its operating expenses during these initial months and still have cash left in its bank account.

For the purpose of illustration, suppose our startup restaurant was projected to have a total negative cash outflow over the first eight months of $75,000 before revenues began to exceed expenses. Now, further assume that the owner wanted to keep a minimum of $30,000 in the company's bank account. This means another $105,000 must be added to the original estimate of $542,000 for startup costs.

The required initial capitalization now becomes $647,000. The owner needs to raise this amount from a combination of equity contributions, loans or other forms of finance.

Sources for Equity

Although an owner would have to give up a portion of ownership, equity contributions are less burdensome on the company's cash flow during the early months of operation. The following are possible sources for equity:

  • Friends and relatives.
  • Angel or seed investors.
  • Personal savings.
  • Crowdfunding.
  • Bootstrapping.

Sources of Debt or Other Long-Term Financing

Ideally, you don't want to start out with too much debt that requires regular principal and interest payments because of the uncertainty of cash flow in the early stages of growth. In addition, capitalization rules from lenders will limit the debt-to-equity ratio. This is a good practice for entrepreneurs to follow. Some sources of debt include:

  • Life insurance policies.
  • Leasing companies for equipment.
  • Trade or supplier credit.
  • SBA loans.
  • Equipment loans.
  • Commercial banks.
  • Home equity loans.
  • Commercial finance companies.

According to the U.S. Bureau of Labor Statistics, only 20 percent of new businesses will make it past the first year of operation. Failure is not usually due to lack of a great product or because of stiff competition. It's because of cash-flow problems.

Companies often don't start out with enough initial capitalization to cover all expected and unexpected startup costs and to support the operations through the negative cash flow in the early months. The importance of adequate capital and realistic projections of revenue cannot be understated.

References

About the Author

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.

Photo Credits

  • Mike Watson/moodboard/Getty Images