Capital — the funds available to a business — is the lifeblood of any successful venture.

It can
be contributed by owners and investors, borrowed from lenders or generated internally through
operations. Sufficient capital is essential to stay in business, avoid bankruptcy and feed growth.
But maintaining adequate capital balances can be a challenge, especially for new and small
businesses. When a business’s capital balances are insufficient, it is said to be undercapitalized.
Operating in an undercapitalized state is not ideal, but it’s not always fatal. As such, it is
important to understand the causes and effects of undercapitalization, as well as how to address
it, even for business owners who think their personal assets are safe from creditors because the
company is incorporated.

What Is Undercapitalization?
Undercapitalization occurs when a business doesn’t have enough cash to maintain operations
and pay creditors. The emphasis on cash is what makes capitalization different from the accrual
accounting definition of “profitability”, which is a company’s ability to use its resources to
generate revenues in excess of its expenses. A company that is profitable “on paper” can still be
undercapitalized in real life. Undercapitalization can be caused by imbalanced cash inflows and
outflows, which can become problematic over time. In other cases, undercapitalization
describes a situation where a company simply needs more funds than it has or can access in
order to grow. Undercapitalization is an imbalance that occurs when a business doesn’t have
enough cash to pay creditors and maintain operations.

Undercapitalization Explained
When a company is undercapitalized, it is unable to pay for its obligations, such as rent,
supplies, payroll and debt. Said another way, undercapitalization creates a liquidity problem. A
business may become insolvent if its cost structure is larger than its ability to generate profits
and it lacks access to external sources of capital, such as loans or owner contributions.
Even profitable, liquid companies may experience undercapitalization. If a company doesn’t
have the capital to invest in additional manufacturing equipment or hire staff in order to capture
increasing demand, undercapitalization can create missed opportunities. Similarly,
undercapitalization can limit a company’s ability to expand into new markets or develop new
products, creating additional opportunity cost.
Without proper financial management, new and small businesses are especially susceptible to
undercapitalization, although it can happen to companies of all sizes and in all industries, as
well as to business units within larger companies. Funding a new venture requires accurately
quantifying the amount of capital necessary to start up the business and to support operations
until it ramps up and becomes self-sustaining. Developing these financial plans and projections
is particularly challenging since it requires estimating both initial outlays, such as licenses,
equipment and deposits, and ongoing operating expenses, including rent, payroll and inventory
purchases. Underestimating can cause startup funding to be too low, leading to
undercapitalization, as can overspending an accurate budget. Further complicating matters, a
 new business without credit history may not be able to borrow to bridge a temporary gap in
capital.
Undercapitalization can be a significant challenge for small businesses if they haven’t prepared
for contingencies that impact cash flow, such as market downturns, litigation or natural
disasters. Preparations include establishing a rainy-day capital fund and setting up access to
credit or additional investment. However, small business owners may be limited in their ability
to make additional investments in the business, and credit limits for borrowing may be
inadequate. For this reason, undercapitalization can also mean that funds aren’t available for
growth or expansion.
Causes of Undercapitalization
Undercapitalization, or not having enough funds to sustain business operations, can be caused
by any number of internal or external factors. It’s important to recognize the reasons
undercapitalization occurs since it’s a leading cause of failure for small businesses. In fact, one
analysis indicates that lack of adequate capital caused almost 40% of a sample of more than 100
recent startups to fail. Common causes of undercapitalization include:

 Underestimating required costs, which can lead to failure to raise adequate startup or expansion
capital.
 Declining cash flow from reduced product sales or depressed economic conditions.
 Unavailability of credit, either due to lack of/poor credit ratings or limited credit lines.
 The use of short-term loans — debt due in a year or less — rather than permanent funding from
long-term loans or open-ended equity investments, which creates a cyclical under-resourcing of
capital.
Intentional underfunding is a less common cause of undercapitalization that can lead to
significant legal consequences. Some entrepreneurs opt to intentionally minimize the amount of
capital they contribute to a business with the expectation of shielding personal assets in the
event the business fails or is sued. This can lead to undercapitalization if the amount of
contributed capital is less than the business needs to reasonably operate and pay its debts.
However, this strategy has been challenged in courts, even for businesses that are organized as
corporations or limited liability corporations. The courts have established a precedent of
“piercing the corporate veil,” holding the entrepreneur personally liable for intentionally
undercapitalizing the business.
Effects of Undercapitalization
Businesses that are undercapitalized and experiencing liquidity problems are in a precarious
situation. The worst-case scenario is business failure, but that is not an inevitable result.
Sometimes undercapitalization simply constrains future growth. In other cases, it makes a
business more susceptible to risk. Some of the effects of undercapitalization include:

 Business failure due to insolvency, which is the most dire effect of undercapitalization.
 Lack of payment or recurring delinquent payment, which can cause supply-chain issues.
 The inability to produce inventory and make sales due to these supply-chain issues, which
perpetuates a downward spiral for cash inflows.
 The inability to hire the necessary employees to keep operations running.
 Inflexibility to weather any negative changes in cash flow, which significantly increases the risk
of insolvency.
 Corporate owners possibly being held personally liable in cases where personal and corporate
assets are commingled, the corporation does not keep adequate records or corporate owners
intentionally defraud their creditors.
Undercapitalization can be deceptive for investors in the short run. When analyzing a business
that is still operating but has an unusually low amount of capital, certain investment metrics can
be misleading. For example, the return on equity percentage will look higher than comparable
but more amply capitalized businesses because the value of the equity in the calculation’s
denominator is smaller. Similarly, shareholders of an undercapitalized public company may
receive higher dividends than an adequately capitalized company would return because the
undercapitalized company is not properly reinvesting in the business. In turn, the higher
dividends and return ratios inflate the share price in the short term, giving shareholders
unsustainable appreciation in the share price. In all cases, a company that is undercapitalized
and unable to fund its operations and pay its bills faces insolvency in the medium to long term.

Solutions to Undercapitalization
Undercapitalization is a primary reason that new and small businesses fail, but it doesn’t have to
be the case. There are several things a business can do to help prevent undercapitalization, as
well as approaches to help monitor capital levels for early detection of issues. At the same time,
it’s important to do some contingency planning. More specifically, the following solutions may
be helpful in avoiding undercapitalization.

 Create a detailed business plan early in the process that can be used to attract investors and
lenders and serve as a guide for creating the organization, standing up product development and
achieving financial success.
 Take a holistic approach to develop startup or expansion capital needs, being as thorough and
inclusive as possible. Consider engaging experts or using resources like the Small Business
Administration guides for help.
 Use a conservative mindset when estimating capital needs, skewing to the high end for costs
and the low end for projected cash inflows. Add in 5% to 10% extra as a reserve.
 Set up credit lines in advance of needing them so that agreements are in place and capital is
standing by.
 Establish a history of making payments on time with a lender, which may make it easier to
obtain funding from that lender down the road if needed.
 Develop a strong connection with customers to ensure healthy operating capital. Strong
customer service, product differentiation and well-trained employees can help achieve this goal.
 Develop a budget aligned with the business plan that can be used to manage cash inflows and
spending. Regularly monitor and analyze any deviations from the budget.

Undercapitalization Examples
Undercapitalization is a common issue for new, small and growing businesses. Underestimating
the level of startup capital needed for a new business is a common mistake. Similarly, it’s easy
to imagine a thinly profitable small business without external investors or credit lines getting
into a situation where it can’t pay its bills and has nowhere to turn for additional capital. Less
intuitive are the cases of undercapitalization for growing businesses because growth might infer
financial strength.
Here’s an example of undercapitalization in a growing, small business: Hypothetical business
KMR Bakery specializes in gluten-free delicacies. Its sole owner has created a stable business
with long-term, allergen-trained employees, a loyal customer base and steady positive cash flow
that is used to maintain a constant supply chain and support the owner’s family. When another
specialty bakery unexpectedly closes in the neighboring county, KMR experiences an influx of
customers, and demand exceeds supply. This causes stockouts and frustrates the owner and the
employees, who turn new and regular customers away from empty shelves. The owner would
like to expand her operations to capture the demand and serve the community but never had the
need to establish a bank credit line. She also doesn’t have the amount of personal funds needed
to build more space, buy equipment and increase her inventory of supplies. KMR is an example
of a liquid business that is undercapitalized.

Overcapitalization
The term “overcapitalization” refers to a situation wherein the value of a company’s capital is
worth more than its total assets. Put simply, there is more debt and equity compared to the
value of its assets.
When a company is overcapitalized, its market value is less than its total capitalized value or
its current value. An overcapitalized company may end up paying more in interest
and dividend payments than it can sustain in the long term. Being overcapitalized means that a
company’s capital management strategies are running inefficiently, placing it in a poor
financial position.

Understanding Overcapitalization
Capitalization is a term used in corporate finance to describe the total amount of debt and
equity held by a company. As such, it defines the total amount of money that is invested in the
company itself. This includes both stocks and bonds.
Companies can be either undercapitalized or overcapitalized. Here, we focus on the latter, but
we go over what it means to be undercapitalized a little further down.
Being overcapitalized means that a corporation’s issued capital exceeds its operational needs.
The heavy debt burden and associated interest payments that an overcapitalized entity carries
can be a strain on profits and reduce the amount of retained funds that the company has to
invest in research and development (R&D) or other projects. Raising capital may be difficult,
as a company’s stock may lose value in the market. As a whole, being overcapitalized puts a
strain on a company’s earning potential.
There are several reasons why companies may find themselves in a position where they are
overcapitalized. Some of the most common causes of overcapitalization include:
  Acquiring assets that don’t fit with the company’s operations
 Purchasing high-priced assets
 Very high initial or startup costs, which can appear as assets on a company’s balance
sheet
 Loss of or drop in earnings due to changing economic or political conditions
 Poor management
Companies may also find themselves at risk of becoming overcapitalized when they either
mismanage or underutilize the capital they have.
An overcapitalized company has several options available to correct the situation. Some of
these options include:

 Reducing its debt load by refinancing or restructuring debt

 Cutting interest payments by paying off long-term debts
 Conducting a share buyback from investors, which can effectively reduce a company’s
dividend payments
If none of these options is viable, then the company may want to seek out a merger or be
acquired by another entity.
Overcapitalization isn’t just used in corporate finance. It’s also commonly used in the
insurance industry. When used in this context, the supply of available policies exceeds
consumer demand. This situation creates a soft market and causes insurance premiums to
decline until the market stabilizes. Policies purchased when premiums are low can reduce an
insurance company’s profitability.

Special Considerations
Although it may seem detrimental to a business, there is one advantage to being
overcapitalized. When a company finds itself in this situation, it may have excess capital or
cash on its balance sheet. This cash can earn a nominal rate of return (RoR) and increase the
company’s liquidity.
The excess capital also means that the company has a higher valuation and can claim a higher
price in the event of an acquisition or merger. Additional capital can also be used to fund
capital expenditures, such as R&D projects.
Here’s another way to look at overcapitalization: When a company raises capital well above
certain limits, it may become overcapitalized. Again, this isn’t good for the company, as its
capitalized value is higher than its market worth.

Overcapitalization vs. Undercapitalization

The opposite of overcapitalization is undercapitalization. Just like overcapitalization, being
undercapitalized is not where any company wants to be.
Undercapitalization occurs when a company has neither sufficient cash flow nor access to the
credit it requires to finance its operations. The company may not be able to issue stock on the
public markets because the company does not meet the requirements or because the filing
expenses are too high.
Essentially, the company cannot raise capital to fund itself, its daily operations, or any
expansion projects. Undercapitalization most commonly occurs in companies with high startup
costs, too much debt, and insufficient cash flow. Undercapitalization can ultimately lead
to bankruptcy.