Clients often ask what we mean when we talk about “adequate capitalization at start-up.” Adequate capitalization generally describes the ability of a company to meet its capital and operating needs in a manner consistent with its intended business purpose. Some of the major expenses facing start-ups include facility rental and leasehold improvements, salaries and wages, equipment, fixtures, inventory, insurance, advertising and marketing, and business licenses. When a company has an adequate amount of capital, this capital will meet the company’s future financial needs and give the company the ability to pay its debts as they become due.
Business owners frequently underestimate how much capital will be needed to fund operations, resulting in undercapitalization. Companies that are undercapitalized, or without sufficient funding to support its operations, are unprepared to ride out slow periods in the business cycle, fend off new competitors, or fund expansion opportunities.
From a legal standpoint, one of the main concerns with undercapitalization is that it may expose the company’s owners to personally liability for business-related matters. Known in the legal community as “piercing the corporate veil,” this doctrine allows courts to disregard a corporation or limited liability company and hold the company’s owners liable for the company’s obligations. A critical factor in determining whether to pierce the veil of limited liability rests upon whether the owners provided sufficient capitalization for the business.
To avoid undercapitalization and ensure there is sufficient funding at start-up, we urge business owners to consult with their team of accountants, bankers, business consultants and, of course, attorneys at the outset to perform a realistic assessment of their expenses and capital needs to run their businesses well beyond the initial start-up period. According to the U.S. Bureau of Labor Statistics, approximately one-third (1/3) of all business start-ups fail within the first two (2) years of operation and over half fail within their first five (5) years. Having the right amount of capital can be the difference in a start-up company’s succeeding or failing.
If you have any questions regarding this issue, please contact one of our business attorneys at [email protected] or call 412.242.4400.