Undercapitalization Law and Legal Definition
Undercapitalization is a situation in which a business has insufficient funding, or capital, to support its operations. Although undercapitalization can affect any business, it is particularly common and problematic for small businesses. In fact, undercapitalization is one of the warning signs of major financial trouble for small businesses, as well as a significant cause of small business failure. Undercapitalization also acts to limit the growth of many small businesses, because without sufficient capital they cannot afford to make the investments necessary for expansion. In this way, undercapitalization can pose a problem even for profitable small businesses. "What separates the successful entrepreneur from the unsuccessful? In many cases, it seems to be whether the prospective business owner has access to sufficient funds," Brian Hamilton wrote in the Small Business Administration publication Financing for the Small Business. Without sufficient capitalization, companies are unprepared to ride out slow periods in the business cycle, or to fend off a new competitor, or to work through any number of shocks that buffet all businesses from time to time.
There are a number of factors that determine how much capitalization any small business needs. Businesses that offer a service usually require fewer funds than those that manufacture a product. Similarly, businesses in which the owners perform most of the work tend to need less up-front capital than businesses with employees. A company's initial capitalization also depends on the entrepreneur's ability to invest personal funds and institute a sound business plan.
In order to avoid future problems with undercapitalization, entrepreneurs need to perform a realistic assessment of their expenses and financial needs. Some of the major expenses facing a new business include facility rental; salaries and wages; equipment and tools; supplies, utilities; insurance; advertising; and business licenses. Based upon this information, the entrepreneur should prepare a cash flow projection on a monthly basis for the first year. The difference between the funds the entrepreneur is able to contribute, the amount of income the business is expected to generate, and expenses the business is projected to incur provides a rough estimate of the business's financial needs. Ideally, an entrepreneur will secure the necessary equity from various sources to make up the difference and provide the business with sufficient capitalization.
CASH MANAGEMENT AND PLANNING
Managing cash flows is an important aspect of staying ahead of the capital needs that a growing company may have. The goal of cash management is to manage the cash balances of an enterprise in such a way as to maximize the availability of cash not invested in fixed assets or inventories and to do so in such a way as to avoid the risk of insolvency. Factors monitored as a part of cash management include a company's level of liquidity, its management of cash balances, and its short-term investment strategies.
Cash is the lifeblood of a business. Managing it efficiently is essential for success.
In some ways, managing cash flow is the most important job of business managers. If at any time a company fails to pay an obligation when it is due because of the lack of cash, the company is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the prospect of such a dire consequence should compel companies to manage their cash with care. Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk to which the firm is exposed.
Cash management is particularly important for new and growing businesses. Cash flow can be a problem even when a small business has numerous clients, offers a product superior to that offered by its competitors, and enjoys a sterling reputation in its industry. Companies suffering from cash flow problems have no margin of safety in case of unanticipated expenses. They also may experience trouble in finding the funds for innovation or expansion. It is, somewhat ironically, easier to borrow money when you have money. For this reason, planning ahead is essential. Knowing when new funds will be necessary and securing those funds ahead of the need is far easier than approaching a bank once there is a funding crunch in the business.
UNDERCAPITALIZATION AND CORPORATE LIABILITY
A little-known problem associated with undercapitalization is that it can increase the likelihood of the owners of a corporation being held personally liable for business-related matters. One of the main reasons that entrepreneurs choose the corporate form of business organization is to protect themselves against personal liability for business debts and court judgments. Incorporation does not afford automatic protection, however. Corporate owners can be held personally liable in a number of situations, including cases where personal and corporate assets are commingled, the corporation does not keep adequate records, or corporate owners intentionally defraud their creditors.
But perhaps the most critical factor in determining whether there should be personal liability for corporate debts is whether the owners provided sufficient capitalization for the business. The ultimate test is whether there are enough corporate assets to satisfy corporate obligations. For example, an entrepreneur could not contribute only $500 to start a new business, knowing that it actually required an initial capital outlay of $10,000, and expect his or her personal assets to be protected in case the business became insolvent. In this instance, a court would be likely to rule that the extreme undercapitalization of the corporation made the owner personally liable for its debts.
SEE ALSO Banks and Banking; Capital Structure; Cash Management; Debt Financing; Equity Financing; Finance and Financial Management
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Hillstrom, Northern Lights
updated by Magee, ECDI