No founder goes into business with the intention of running out of capital. However, research shows that as many as 29% of startups fail because they run out of money.
Businesses that become undercapitalized face increased risk of operational disruption, lost market share, and even total business failure.
However, there are ways for businesses to prevent this scenario and address undercapitalization should it occur.
What is undercapitalization?
Undercapitalization refers to a business's state of not having sufficient financial resources to operate or achieve growth.
This can occur for many reasons, stemming from limited startup capital to poor cash flow management, mismanaged investments, or a slowdown in demand.
Regardless of the cause of undercapitalization, businesses in this scenario may struggle to make ends meet and cover financial obligations. If they are not able to secure additional funding, they may find themselves insolvent and shut down operations.
Causes of undercapitalization
As mentioned above, there isn’t just one source of undercapitalization for a business. There are many different reasons this may occur, which will determine the proper preventative measures that teams can employ.
Insufficient startup capital
One key source of undercapitalization is if the business lacks sufficient funding from the start.
Whether the company’s founder plans to bootstrap operations, borrow money from a friend or family, or secure business capital from an investor or creditor, not having enough seed capital can limit a company’s ability to take off.
In other words, they may not be able to hire the right employees, invest in the necessary equipment, and purchase any other resources or services that will help the business get started and generate revenue to become self-sustaining.
Rapid growth outpacing capital acquisition
It’s also possible that a company experiences rapid growth in demand without funding following suit. This puts the business in a tough financial position as they attempt to deliver the promised goods or services.
For instance, maybe a startup secures a large contract that will pay after delivery; however, it doesn’t have the capital to cover costs upfront to meet the contractual obligations.
Poor financial planning
A company may also face undercapitalization due to improper cash flow management and forecasting.
While an inaccurate forecast or budget may seem harmless, it can lead to a chain of poor financial decisions that ends in a cash flow shortage.
For instance, an overly optimistic forecast that anticipates significant sales growth can cause the business to overextend itself in terms of hiring, procurement, and other investments.
Excessive debt
Another source of undercapitalization comes from a business taking on outsized debt.
The debt repayment schedule can create high fixed costs for the business for months or even years. In turn, it may have little wiggle room to absorb financial shocks during a downturn or invest in further growth initiatives.
Inefficient cost management
A business that lacks cost management and poor spend visibility can also find itself in a state of undercapitalization.
Even if the company successfully grows and operates for a period of time, it can still end up running out of capital if spending gets out of control or does not grow in proportion to sales.
Consequences of undercapitalization
The symptoms of undercapitalization may look different for businesses based on their growth stage, industry, and other factors.
Here are some of the key signs that a business lacks sufficient capital:
Cash flow problems
A company with undercapitalization may face cash flow problems in the short term, as it does not have the cash on hand to meet its obligations.
Cash inflows may be expected in the future; however, timing issues between planned outflows can create a pinch in the meantime. In practice, this might lead to paying vendors late to cover payroll, or missing rent payments until customer invoices are paid.
Operational inefficiencies
Businesses may also face operational disruptions and inefficiencies when dealing with undercapitalization.
If the team is short on funding, it may need to pull back on software licenses, machinery, or other resources employees depend on to work efficiently. Or, leaders may be faced with cutting headcount, which can put additional strain on the team members who remain.
Increased risk
Businesses that are undercapitalized have an increased risk of becoming insolvent or going bankrupt.
Amid cash flow shortages and operational inefficiencies, companies may take on short-term, high-interest debt in the meantime to cover costs.
However, if issues persist, they may have no choice but to cease operations and liquidate remaining assets to pay back creditors.
Stifled growth
Even if a company can cover its obligations and support day-to-day operations, it may not be able to pursue growth opportunities if it lacks sufficient funding.
This can stagnate growth and lead to a loss of market share to competitors, which can exacerbate existing financial issues and lead to a further financial decline.
How to address undercapitalization
Companies have a few different approaches to address or prevent undercapitalization, such as:
Secure additional funding
The first option for the business is to secure additional funding. Though this may be easier said than done, this can be done from a few different sources, including:
- Traditional business loans
- Business line of credit
- Business credit card
- Bootstrapping
- Personal loan from a friend or family member
- Grants
- Crowdfunding
- Venture capital
- Angel investors
- Invoice factoring
- Equity
Each option has its pros and cons, and may or may not be available to the business based on its circumstances. However, they are all viable options that can help keep the business afloat until its cash situation normalizes.
Improve cash flow management
Another option is to strengthen cash flow management, helping to time cash inflows and outflows more effectively.
This may require adjustments to existing accounts payable and accounts receivable practices. For example, teams could try negotiating with vendors for more favorable terms, like net 30 instead of net 15, giving them more time to pay invoices.
Alternatively, it may be worth the effort to collect unpaid customer invoices or shorten payment terms to speed up cash inflows.
Cut costs
Cutting costs is not always comfortable, and may not be the right move for all businesses with lean operations.
However, it can be a viable option that helps stop or reduce cash outflows while a business secures more capital.
When taking this route, look for sources of spending that won’t detract from operational efficiency. One example of this is to find unused software licenses that can be cancelled, not taken away from those who rely on the system to complete their job duties.
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Frequently asked questions
What is an example of undercapitalization?
An example of undercapitalization is when a startup company is in the early stages and has not yet secured the funding it needs to hire employees, rent an office space, or invest in marketing. Without an established track record or business credit score, the founder may not be able to access traditional funding options.
If they can’t rely on their own personal savings or secure an investment from an external source, they may be left with non-traditional funding sources at higher interest rates, which can create further financial challenges.
What is the difference between undercapitalization and overcapitalization?
When a business is undercapitalized, it lacks sufficient financial resources to cover its obligations and pursue growth. On the other hand, a business that is overcapitalized has more capital than is needed, which can lead to inefficiencies and stagnation.
