Whether you want to launch a business or grow it, you may have the need to capitalize it. In short, this means financing it. And in doing so, there are things to consider as you open your doors, or take your business to the next level.
Technically speaking, capitalization refers to the cost of equipment that is written off as depreciation over time. It also refers to the converting of retained earnings into capital or of an operating lease into a capital lease. In general terms, it means the investment you make in your business, generating money to make the business happen. It may be called funding, backing, capital investment, or owner’s stake.
When you capitalize a business, you’re able to combine funding with your operating cash flow to pay for assets such as equipment, vehicles and real estate, or plan for growth through purchasing inventory, hiring employees, or financing receivables. It also allows your business to reserve funds for emergencies.
There are many ways to capitalize a business. Two of the more popular ones are equity or debit funding, or a combination of both.
As in other financial situations, equity basically means ownership. Capitalization through equity funding involves the investment of the owners, which can take on many forms. Investors can own stock or shares in your business, or partners can be issued partnership interests.
Equity funding can be beneficial in that there is no debt involved and therefore no credit history is required. The money comes outright from the “owners,” so in most cases there’s no need to pay back investors.
The downside is that while investors provide essential funding, they also gain important rights. You may lose some control over your business as every investor will be able to have a say in how funds are spent. If your business is your baby, you may not want to relinquish that kind of power. In addition, in most cases, investors also recoup their share of the profits, which may end up being more than the cost of a loan.
Another way to capitalize a business is through debt funding. This allows you to take immediate action to open your doors or grow your business by taking out a loan.
There are many ways to do this, whether direct financing through a bank or more complicated arrangements such as with angel investors or venture capitalists. Debt funding is beneficial in that you don’t have to give up any ownership interests. The business remains in your control. At the same time, you make regular payments that can help you build business credit. And going forward, the interest you pay on the loan can be written off as a business expense.
The downside of debt financing is that you’ll need enough cash flow to make regular loan payments. Not making timely payments can hurt your credit rating. Taking out a loan can also can increase your debt-to-equity ratio, which can paint the business in a negative light. Another disadvantage is the debt is often tied to collateral, which may be the business itself or the owner’s personal assets.
Something to consider when capitalizing your business is the opportunity to capitalize interest. This refers to the interest you pay on loans to finance your long-term assets. When you capitalize interest, you add the cost of the interest to the book value of the long-term asset.
In that way it’s seen as a depreciation expense rather than an interest expense. This can reduce the business’s profit “on the books,” while not reducing its cash flow.
The downside of this option is that you cannot realize the tax benefits in the same year the loan is taken out. The interest expense can be recognized as a depreciation expense in a later period.
Capitalizing your business is something every owner must consider whether they’re just starting out or they’re ready to grow, acquire, and move into new markets. Many times, the capital comes from a variety of places – owner’s savings, personal investors, interested partners, or long-term business loans. However, you choose to obtain funding, there are options that can help you succeed.
Authored By Diedre Barret – Senior Vice President of Sales and Marketing for Guaranty Bank