Undercapitalization is a challenge for most startups. This happens even when the founders have compelling visions and well researched plans.
Entrepreneurs are risk takers. Many successful businesses were started with very little or no capital at all. Despite that, many businesses die in the first 2 years because they run out of money.
Entrepreneur.com defines undercapitalization as: “The condition that exists when a company doesn’t have enough cash to carry on its business or pay its creditors.” In other words, the business is broke and cannot pay its bills or debts.
Common causes of undercapitalization
#1: Poor startup planning
You haven’t researched and planned for your business adequately. Due to this, you don’t know all the startup and growth financial needs for your business.
#2: High and unnecessary startup expenses
You start off with expenses that could have been avoided, including:
- hiring employees before you need them.
- buying expensive furniture and equipment.
- renting an office when you could have started from home.
- having a product or service that takes too long to sell or is too expensive to create.
- founders insisting on getting high salaries from the beginning.
- having just enough money for startup while expecting the business to generate income from the word go.
#3: Unwise spending after startup
Poor personal financial habits get transferred into your business. You end up spending business money as unwisely as you do your personal finances.
One place to watch your spending in marketing. Don’t invest in marketing that requires large sums of money. Look for free and affordable ways of promoting and growing your business.
#4: Unclear sales cycle
Every industry has an average time span between marketing and making sales. Not understanding this cycle will lead to spending a lot of time and/or money marketing your product or service.
8 ways to avoid undercapitalization
1. Proper startup research
2. Create a business plan
Your business plan should include a comprehensive financial plan. Patsula Media has all the resources you need to create your business plan.
3. Follow the small business leaders in your industry
First, identify what they’re doing to grow their businesses. Next, replicate what they’re doing without copying them. Put your own unique slant to what they do to differentiate your business from the others.
4. Start small and grow with time
This will give you a chance to learn from the market while still selling. You can improve on your product or service with the feedback you get from the market. Also, consider starting with leased or second hand furniture so that you reduce costs.
5. Have accountability
Be accountable to someone or to a group that can keep you in check. Accountability can come from your business partner(s), a mastermind, hiring an accountant, working with a coach or mentor, or putting in place an advisory board.
Take care to only take advice from people who have experience in the business or industry. Avoid advice from well-meaning friends and family who have unproven theories. In all cases, research the advice to find out if it’s viable for you.
6. Take care of finances
Get 30% to 50% more startup capital than you think you need. This will give you additional security should the business not take off as expected. It will also come in handy if you meet unexpected challenges. Get a business or SACCO loan to help with your startup costs if you can.
Have a personal financial cushion if you’re going into the business full time. Your cushion should cover your personal expenses for 6-12 months. Personal expenses include rent, fuel, food and supplies, medical insurance, and your monthly bills.
Finally, invest in proper financial and business management education so that you avoid or overcome financial challenges.
7. Get business partners
Find people to start the business with and allow them to invest in your business. Although this will reduce your share and decision-making power, it allows you to have a bigger financial cushion. You’ll also have a team to brainstorm with, be accountable to, and who have your back.
8. Start selling before you start the business
If possible, start selling as soon as you can and don’t wait for things to be perfect. Once you start selling, treat your customers very well. Give them outstanding customer service so that they come back and refer others to you.
Referral marketing is one of the most effective marketing tactics for all industries. It’s also easier to sell to people who have already purchased from you than to look for new customers.
My personal experience with undercapitalization
I’m very familiar with this situation because it happened in my first business. My business partners and I started with a clear idea of what we wanted and created a detailed 5 year business plan. We also chipped in enough money to set up and run the business for the first 6 months.
Unfortunately, we set up the business in an election year in Kenya (2007). The crisis that followed that election led to massive business failure all over the country. It didn’t help that we had virtually no business knowledge or experience, and that our marketing was very poor.
Also, our business plan didn’t include a comprehensive SWOT analysis. And so we hadn’t seen the huge threat elections in our country pose to business.
The election crisis led to very low income in the first 6 months of 2008. By the time business picked up in the second half of 2008, it was too late for us. As a results, we finally ran out of money and closed down in April 2009.
This experience came in handy when I was setting up my next business. The second time round, I took all the steps to ensure that my business would survive beyond startup.
Undercapitalization is a huge topic and it’s not possible to cover it fully in one article. Below are some useful articles:
- 9 Brutal Startup Mistakes That Can Kill Your Business (and How to Avoid Them).
- Entrepreneur.com – Undercapitalization.
- Inc.com – Undercapitalization.
- Undercapitalization as a Contributing Factor to Business Failure for Women Entrepreneurs.
- The Myth of Undercapitalization – Six Ways Entrepreneurs Achieve Success in Spite of Start-Up Money.
- Overcoming Financial Problems as a Small Business.
- Undercapitalization: One of Risky Behaviours of Entrepreneurs (if you’re interested in franchises).
Your next step
In conclusion, undercapitalization is a big threat to startups. As has been noted, you should answer these questions for your business:
- Do you have enough capital to start and run your business for the first year?
- Have you researched your industry and completed a SWOT analysis?
- Is your financial plan ready? Has it considered all startup and operating expenses?
- What about marketing - what will you do to get your business known and trusted by people?
I’d love to hear from you so please share your experience in the Comments below. Also, feel free to share one tip that helped you avoid or recover from undercapitalization.
(Image Credit: Stuart Miles at Free Digital Photos)
The complete Common Business Startup Mistakes series is:
- Part 1: Lack of Vision.
- Part 2: Poor Business Startup Preparation.
- Part 3: Undercapitalization.
- Part 4: Rigid Mindset
Starting a business while still employed need not be a hassle. Sign up for this Teleclass with Business Coach Caroline Gikonyo, and find out how you can start your dream business without giving up your job.