What Does it Mean to Be Undercapitalized?

One of the biggest issues that many businesses face is undercapitalization. Although undercapitalization can happen to any business, it is most common in small units. If left unaddressed, undercapitalization can cause a business to shut down or fail severely.

To overcome undercapitalization, a business owner should create an effective policy to combat the problem.

• Undercapitalization can occur during periods of recession or instability in the market. The reason for this is that the company has not allocated adequate amounts of capital. As a result, it cannot generate enough cash to support its day-to-day operations. This can lead to labor-management conflicts and even consumer perceptions of excessively high dividend rates. Further, undercapitalization may cause dividends per share to decline, and the profit rate will fall relative to peer companies and industry benchmarks. This can have a negative impact on the employees, especially those earning fixed salaries.

• Undercapitalization can also cause unfair share value manipulation. A boutique sunglasses maker may not be able to meet demand if it lacks the capital needed to make the necessary purchases. To avoid undercapitalization, a business may take out a loan or seek investors. If the business is undercapitalized, the business will then have to plan ahead for future sales as compensation for the investors. However, this method may not be ideal for all businesses.

• Undercapitalized corporations can leave entrepreneurs personally liable for business matters. These entities are more likely to involve commingled assets, defrauded creditors, and inadequate records. As a result, it is important to understand these issues and how to protect yourself. If you're undercapitalized, you should seek legal counsel. If you're a business owner, it's important to protect yourself from this risk.

• Don't let the government dictate your business. Regulatory bodies can change laws and regulations to benefit the economy. For example, the Federal Deposit Insurance Corporation Improvement Act of 1991 prohibits the Federal Reserve from lending to banks that are undercapitalized. The FDI Act also puts strict rules on compensation for senior executives. In many cases, an undercapitalized mutual thrift can use conversions to raise capital to help itself recover from its undercapitalization.

Avoid the undercapitalization trap. Reach out to us today to plan for your company’s future tomorrow.