Black Banks - Not all Capital is Created Equal!

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From the moment humans began keeping track of money, they have been mindful of their capital; especially in business.   One definition of capital is wealth!   Wealth is defined as money or property, which is owned or employed in business by an individual or a firm.  With that being said, not all capital is created equal.  How your business is capitalized can have a major impact on its potential for success!

Let’s say that you are a great cook and have a wonderful idea for a new restaurant.  After searching for a while, you come across a nice space for lease.  Upon completing the necessary due-diligence on the new space, you calculate that it will cost $100,000 to renovate the property, to buy new equipment, to purchase utensils and accessories.  Not having the capital on hand to begin renovations, you make the decision to go to the bank.  After meeting with the loan officer, the officer approves $80,000 for your company, but makes you aware that you will need to raise the additional $20,000. 

Having $13,000 saved, the decision is made to raise the remaining $7,000 from your favorite Uncle Joe.  After speaking with Uncle Joe, he makes you aware that he does not need it back immediately.  Congratulations, you now have the capital to start your new restaurant!  The $100,000 capital structure contains a bank loan, a “patient” family loan and equity.

Patricia Mitchell, is executive vice president of Industrial Bank, and her brother B. Doyle Mitchell Jr. is its president and chief executive. Their grandfather founded the bank in 1934. (Ricky Carioti/The Washington Post)

 

The largest part of your capitalization is the $80,000 bank loan, which is typical for a small business.  But unlike Uncle Joe, bank loans are not “patient”.  Banks demand regular repayment, usually on a monthly basis.  And bank loans come at a cost.  If you are paying 6.50% on the $80,000 loan over seven years, the payment will be approximately $1,188 per month.   In the beginning,  it might be hard to attract enough paying  customers to  make  such an hefty  payment, understanding that a restaurant requires operating expenses that includes utilities, payroll, insurance costs and more.

You may suddenly find yourself wishing that you had borrowed more money from Uncle Joe and less money from the bank!   Had you borrowed only $40,000 from the bank and the remaining from Uncle Joe, you would have cut your monthly bank payment in half, to only $594.  The benefit of a patient loan is that it does not need to be repaid immediately, which is particularly helpful during the start-up phase of a business.  In some cases, Uncle Joe might not even charge interest, although with a larger loan amount of $47,000, he may require that you sign a not evidencing the loan.

 

Keeping an eye on how your business is capitalized and how well it is capitalized could mean the difference between Success and failure!

 

Also considering, for that loan amount, Uncle Joe might even ask for an ownership stake in your new business.  If you give your favorite uncle an equity stake in your business, he now becomes your partner.   He would be entitled to his share of the profits from the business, sometimes without doing any of the work.  A partner would have the right to also have some input about the future of the direction of the business.  Considering also that it may not escape Uncle Joe that he has more money in the business ($47,000) than you do ($13,000).

With this understanding, you may decide to use your own money and not bother borrowing from the bank or Uncle Joe.  However, in business it is important for most business owners to leverage their own cash by using other people’s money.  Also, if you decide to wait and save the $100,000 on your own, your business might take years to get off the ground.  If you spend all of your own savings on the new business now, you might find it difficult later to get help from the bank or Uncle Joe.  Young entrepreneurs must position themselves to have enough cash on hand to handle all of the rainy days and avoid being undercapitalized.

Keeping an eye on how your business is capitalized and how well it is capitalized could mean the difference between Success and failure! 

Whether you are just getting started in business or have been in business for years, contact Industrial Bank today to assist with capitalizing your company.  Industrial bank can be reached at (202) 722-2000. 

 

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Written by

Doug Dillon, SVP Chief Lending Officer

Doug Dillon, SVP Chief Lending Officer


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