By Entrepreneur Staff


Undercapitalization Definition:

The condition that exists when a company doesn't have enough cash to carry on its business and pay its creditors

When you're launching a business or starting out as the new owner of an existing business, proper planning and research are absolutely necessary. Undercapitalization can be a major problem, one that may lead you right out of business.

You don't necessarily need piles of money to start a business. Apple Computer was started in a garage by Steve Wozniak and Steven Jobs. UPS (United Parcel Service) was started in 1907 when founder Jim Casey borrowed $100 from a friend. Yahoo! was founded by a pair of Stanford University graduate students, Jerry Yang and David Filo, to help their fellow students locate cool Web sites. There's nothing wrong with this approach if you're willing to invest a great amount of time and energy into making the business work. But keep in mind that undercapitalization is the number-one killer of start-up businesses. Don't skimp on getting enough money to start your business right.

To determine how much you'll need for start-up, account for all opening expenses along with your initial operating expenses. Although different businesses have different costs associated with them, the main start-up costs include these:

Rent. Under many lease agreements, you'll be expected to provide the first month's rent plus a security deposit. Many leasors also require the last month's rent.

Phone and utilities. Some telephone and utility companies require deposits, while others do not. A deposit may not be required if you own real estate or have a previously established payment record with the company. Telephone deposits are determined by the number of phones and the type of service required. Unless you need a large number of phones and lines, the deposit is likely to range from $50 to $200. Deposits for gas and electricity (when required) will vary according to your projected usage, so get accurate information and carefully project your numbers.

Equipment. Equipment costs vary from one business to another. At a minimum, most businesses need office equipment, signage, and security systems. To determine your costs, list all the equipment you must have to efficiently operate your business. Next, price those items by obtaining quotes or bids from at least three vendors. Use the quotes you receive to estimate your start-up equipment costs.

Fixtures. This broad category includes partitions, paneling, signage, storage cabinets, lighting, checkout counters, and all shelves, table stands, wall systems, showcases, and related hardware for product display. The cost of fixtures depends on your business location, the size and condition of your facility, the type of business you're in, what kind of image you want it to project, and whether you're purchasing new or used fixtures.

Inventory. Like equipment, inventory requirements vary from business to business. Some businesses, such as retail stores, are inventory-intensive, whereas others, such as personal shopping services, don't require any inventory at all except office supplies.

Leasehold improvements. These nonremovable installations, either original or the result of remodeling, include carpeting and other floorings, insulation, electrical wiring and plumbing, bathrooms, lighting, wall partitions, windows, ceiling tiles, sprinkler systems, security systems, some elements of interior design, and sometimes heating and/or air-conditioning systems. Because the cost of improvements can vary tremendously, get several estimates from reputable contractors.

Licenses and tax deposits. Most cities and counties require business operators to obtain various licenses or permits to show compliance with local regulations. Licensing costs vary from business to business, depending on the requirements of your particular location. In addition to these fees, you'll also need start-up capital for tax deposits if yours is a retail business. Many states require a deposit against future taxes to be collected.

Marketing budgets. Most companies determine their first year's advertising budget as a percentage of projected gross sales, typically two to five percent.

Professional services. Before you officially open your business, get help from a knowledgeable lawyer and accountant who work with small business owners to make sure you meet your legal and tax obligations. Their fees will range according to their expertise, and the location and size of their practices.

Preopening payroll. If your business is going to be a full-time venture, then set aside a salary for yourself in addition to a three-month reserve, just to play it safe. This rule of thumb also applies to any employees you might hire during this phase of business start-up.

Insurance. Plan on allocating the first two quarters' cost of insurance to get your business rolling.

A word of caution when estimating these costs: If there's ever a time to be conservative, it's now. Err on the high side when you project expenses, and on the low side when you project revenue. And don't forget to add a "rainy day" or contingency fund to cover the costs of unforeseen expenses--somewhere around five percent of your budget is a typical amount to set aside. This financial cushion will help you--and your investors--avoid panic in case you're faced with an expense you hadn't budgeted for.

More from Financial Management

Cash Float Accounts

A bank account specifically set up by a business owner to float money through from Business A to enhance the perceived value of Business B

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Cost-Benefit Analysis

A process by which you weigh expected costs against expected benefits to determine the best (or most profitable) course of action

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The value of any tangible property and property rights owned by a company less any reserves set aside for depreciation. Assets don't reflect any appreciation in value unless they're sold for the greater value.

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Debt-to-Equity Ratio

A measure of the extent to which a firm's capital is provided by owners or lenders, calculated by dividing debt by equity. Also, a measure of a company's ability to repay its obligations. If ratios are increasing--more debt in relation to equity--the company is being financed by creditors rather than by internal positive cash flow which may be a dangerous trend.

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