Whether you’re an ambitious entrepreneur, a savvy business owner, or a visionary corporate leader, understanding and managing your capital effectively is your ticket to scaling and boosting profitability.
In this blog post, we’ll embark on an exciting journey through the vital world of business capital, guided by the wisdom of financial guru Greg Crabtree. We’ll unravel the mysteries of the three primary sources of capital—your own hard-earned money, investments from others, and the invaluable contribution of sweat equity. But that’s not all. We’ll also dive into the four types of capital that form the lifeblood of thriving businesses: Trade Capital, Infrastructure Capital, Buffer Capital, and Launch Capital.
Get ready to discover which capital types are crucial for your specific business, and learn actionable strategies to manage and optimize these resources like a pro.
Understanding Business Capital
Capital can often be misunderstood. In simple terms, capital is the difference between your assets (what you own) and your liabilities (what you owe). In other words, capital is also known as equity.
Capital in your business can be used to purchase inventory, new assets such as equipment, and allows you to have the proper amount of cash on hand to meet your core capital target.
Debt and capital are often confused. If you are trying to get a loan from the bank to fund your business this is debt. You can’t consider it as capital. You might hear other people using the term “borrowed capital”, but that is an extreme distortion because debt and capital cannot be the same thing. With debt there are inflexible terms and the money must be repaid.
The Sources of Business Capital
"Each one has its price. Choose wisely and know the reasons for your choice."
- Greg Crabtree
When embarking on the journey of growing a business, understanding the various sources of capital can be transformative. At the core, capital fuels not only the inception but also the ongoing growth and expansion of any venture. There are three primary avenues through which business capital can be sourced: personal funds, other people’s money—which includes tools like angel investors and venture capitalists—and sweat equity. Each source comes with its own set of dynamics, benefits, and risks.
Utilizing Personal Funds: Investing Your Own Capital
Investing personal funds is often the first step for many entrepreneurs. This approach can be seen as both a testament to one’s commitment and a direct control over the business’s financial engagements. By using personal savings or personal assets, you not only retain full equity but also maintain complete autonomy over decision-making processes.
For example, early in Greg Crabtree’s career an entrepreneur was set on starting a business debt free. When calculating the required capital needed to start his business, he fell $40,000 short. Rather than taking out a loan, he sold his land that he owned and made the $40,000 he needed. He never borrowed a dime.
While it can be difficult, it’s not impossible to start a business with your own money. When you use your own money, you handle things with more care. You’ve worked hard to get to where you are and you tend to be more frugal.
When you pour capital into your business you should expect a healthy return. It’s no different than when you make an investment in the stock market you expect to see a return. You can calculate your return on invested capital by dividing your pretax profit by your equity. If you have a healthy 10-15% pretax profit coupled with a core capital target of two months of operating expenses with nothing drawn on credit the rate of return works out to be about 40-50 percent. When you exceed the 15% benchmark of pretax profitability the return goes up to about 60-70 percent.
Leveraging Other People’s Money
Not every entrepreneur is sitting on the capital needed to start a new venture. That’s when utilizing your network is a great option. Generally, using other people’s money should be a last resort. If you can wait until you have enough of your own money, that’s ideal. It’s easier to blow through other people’s money and push off hard decisions.
Using other people’s money requires clear boundaries and expectations to be set. Investors in your business shouldn’t be expecting a salary. Salaries are only paid to those who do a particular job in the business. Investors shouldn’t expect a 20 million dollar return on a $20,000 investment. Additionally, an investor without any expectations can be just as bad.
Other people’s money can come from three sources: family friends, and fools, angel investors and venture capitalists.
Family, Friends, & Fools
Things can get pretty sticky when you do business with family, friends and fools. Yet, this still remains one of the most common sources of capital sourced from other people. Business ventures generally require $100,000 or less of starting capital which is within the reach of personal friends and family.
When close friends and family invest in your business there are often no expectations or unrealistically high expectations. If the business deal goes bad then there’s a lot to lose. Friends grow apart, family members become estranged, and fools often resort to lawsuits.
To help prevent blurry lines and unclear expectations, legal documents should be drawn up. These won’t prevent disagreements or disputes but they will help speed up settlements.
Angel Investors
Angel investors are a much more ideal source of capital as they are accredited by the SEC as having $1 million of net worth. They typically invest between $50,000 and $100,000, making them ideal for startups that may not yet qualify for larger venture capital investments. These investors are often seasoned entrepreneurs or industry professionals, bringing valuable experience and strategic guidance.
Finding an angel investor involves leveraging multiple channels. Networking events and pitch competitions are excellent opportunities to meet potential investors. Local angel investors can be found through the local business community such as the chamber of commerce. Many angels are part of organized groups like The Angel Capital Association (ACA), which have formal application and pitch processes. Online platforms such as AngelList also connect startups with accredited investors. Additionally, seeking referrals from advisors and mentors can be highly effective.
Working with angel investors requires due diligence and clear communication. Research their investment history to ensure alignment with your business vision. Transparency about your startup’s status and plans fosters trust. Though many angels have experience with legal documentation, hiring professional legal assistance is advisable to ensure all agreements are sound. Maintaining strong relationships post-investment through regular updates and open communication keeps investors engaged.
Venture Capitalists
Sourcing capital from a venture capitalist (VC) can propel a startup to new heights but also comes with substantial demands. On the positive side, VCs offer significant funding, enabling rapid scaling and investment in key resources. Besides financial support, they provide industry expertise, strategic guidance, and valuable networking opportunities. This backing from a reputable VC can also enhance a startup’s credibility and attract further investment.
However, there are notable downsides. Securing VC funding often means diluting ownership and losing some control over business decisions. VCs come with high expectations for rapid growth, profitability, and aggressive milestones, which can create substantial pressure. They also typically require a stake in decision-making, sometimes leading to conflicts with the founders’ vision. Furthermore, VCs focus on exit strategies like IPOs or acquisitions to realize returns, which might not always align with the founders’ long-term goals.
VCs expect clear financial metrics, scalability, and a strong management team. They seek startups with a promising market strategy and a clear path to growth. Post-investment, they demand regular updates, transparent reporting, and involvement in key decisions.
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Sweat Equity as a Capital Source
Sweat equity serves as an invaluable yet often overlooked source of capital for businesses, particularly startups and small enterprises. Essentially, sweat equity represents the value that entrepreneurs and their team members contribute to the company through unpaid work. This form of capital is built on the foundation of effort and hard work, enabling businesses to preserve cash and allocate their financial resources more effectively.
One of the most significant advantages of leveraging sweat equity is the preservation of cash. By contributing their labor and expertise without immediate financial compensation, entrepreneurs can retain funds within the business for other essential expenditures such as marketing, research and development, or operational scaling. This strategy can be especially critical during the early stages of the business when cash flow might be limited and securing external funding can be challenging.
To fully capitalize on sweat equity, business individuals often structure their lives to live on minimal to no salary, opting instead to reinvest their savings and any generated profits back into the business. This approach helps in strengthening the company’s financial health and building a robust capital reserve. Ideally, founders and key team members subsist on their savings or low personal expenses until the business achieves a stable pre-tax profit margin, typically 2-3%. At that point, the company can begin to pay market-based wages, as the sweat equity has successfully built the business’s capital base.
It is crucial to track sweat equity accurately to ensure that it does not distort the company’s financial records, especially during tax filings. For example, if a founder’s market-based salary should be $75,000, but they choose to forgo a salary in the first year and take only $50,000 in the second year, they have effectively created $100,000 in sweat equity capital. This quantified value can serve as a significant asset when evaluating the business’s capital structure or when seeking external funding.
There are two primary options for formally recognizing and settling sweat equity. One option is to exchange sweat equity for stock, effectively converting unpaid labor into ownership shares. This not only rewards the contributors but also aligns their interests with the long-term success of the company. Alternatively, businesses can offer ownership stakes in exchange for sweat equity, enabling employees to earn their way into the business.
Exploring the Four Types of Capital Essential for Business Operations
Once you secure funding and launch your business, one of the most critical questions to address is, “What is the return on invested capital (ROIC) for my business model?” To answer this effectively, it’s essential to first understand the four types of capital that play integral roles in your enterprise: Trade Capital, Infrastructure Capital, Buffer Capital, and Launch Capital. Each serves a unique function within the business ecosystem, influencing liquidity, asset management, risk mitigation, and growth potential.
Trade Capital
Trade capital offers a more reliable snapshot of a company’s operational efficiency and liquidity compared to traditional working capital, making it an essential metric for business analysis.Trade capital is derived from the elements of working capital but excludes cash and lines of credit, focusing instead on the operational facets of a business. Specifically, it consists of:
- Accounts Receivable: Money expected from customers for products or services delivered.
- Inventory: The total raw materials, work-in-progress, and finished goods that are ready or will be ready for sale.
- Work in Progress: Partially finished goods that are still in the production process.
It does not include:
- Accounts Payable: Money a company owes to suppliers for products and services purchased on credit.
- Accrued Expenses: Expenses that have been incurred but not yet paid.
- Deferred Revenue: Payments received in advance for goods or services yet to be delivered.
By analyzing these components, trade capital provides a clear picture of how efficiently a company manages its short-term obligations and its ability to sustain operations at a particular sales volume.
Assessing the trade capital percentage relative to revenue against the net income percentage to revenue offers critical insights into a company’s growth strategy:
- Cash-Free Growth Zone: If the trade capital percentage to revenue is lower than the net income percentage to revenue, the company is in a cash-free growth zone. This indicates that the business can grow without significant additional cash investment, as it efficiently manages receivables, inventory, and payables to sustain operations.
- Base Camp Growth Method: Conversely, if the trade capital percentage to revenue is higher than the net income percentage to revenue, the company must adopt the base camp growth method. Here, growth necessitates injecting more cash into the business to finance higher accounts receivable or inventory levels, essential for scaling operations.
Infrastructure Capital
Infrastructure capital refers to the investment in long-term, fixed assets necessary for running a business, such as equipment, furniture, buildings, and leasehold improvements, along with intangible assets like goodwill. It includes the value of these assets minus any debts used to finance them. Properly managing this debt can significantly impact your return on investment (ROI).
While you should adhere to GAAP for compliance purposes there are simpler ways of looking at your numbers from an economical perspective. For example, if you buy a truck, instead of recording the down payment, loan payments, and depreciation separately, you could treat all payments as expenses with fewer accounting entries.
Another example is of a retail store client of Greg Crabtree’s who was financing its buildouts. He recommended treating these financed build-outs as operating expenses (similar to rent), which can significantly improve their Return on Invested Capital (ROIC). Of course if the store failed they would have to pay the debt back but there’s no difference looking at it as an operating expense when it comes down to the economical reality.
Buffer Capital
Managing a business’s finances can sometimes feel like walking a tightrope. You’re constantly balancing between having enough cash to cover unexpected expenses and not tying up too much money that could be used for growth. This is where the concept of Buffer Capital comes into play, a term that may sound technical but is quite straightforward and incredibly useful for any business owner to understand.
Buffer Capital refers to the cash reserves a business maintains to cover two months’ worth of operating expenses. These operating expenses include everything you need to keep your business running, such as salaries, rent, utilities, and other day-to-day costs. The key here is to ensure that this cash is available without relying on a line of credit. Essentially, it’s an emergency fund for your business that can help you navigate through tough times without resorting to loans or external funding.
The idea of maintaining two months’ worth of operating expenses in cash isn’t arbitrary. It comes from extensive research analyzing cash flow data over several years, from many different businesses. Even in the worst months, a normally operating business seldom sees a cash flow dip that deep. This makes two months’ worth of operating expenses a reliable safety net, ensuring that you’re well-equipped to handle sudden downturns or unexpected expenses.
Buffer capital has numerous benefits including:
- Clarity and Confidence: One of the biggest advantages of maintaining buffer capital is the peace of mind it brings. Knowing exactly how much cash is “enough” helps business owners feel more secure. It takes the guesswork out of financial planning and allows you to focus on growth and strategic opportunities.
- Market Power: Having a healthy cash reserve gives you leverage, especially in tough economic times. For example, during the 2008 financial crisis, businesses that had robust buffer capital were able to survive and even thrive, taking over competitors’ accounts who didn’t have such reserves.
- Reduced Over-Leverage Risk: Many businesses fall into the trap of over-leveraging themselves, relying too much on credit and loans to finance operations. Buffer capital reduces this risk by providing a financial cushion that lets you handle short-term needs without increasing debt.
Launch Capital
Launch Capital is essentially the financial cushion needed to cover the operating losses a business incurs before it becomes profitable.
In simpler terms, Launch Capital isn’t just the money you need to get your business off the ground, but it also serves to support your business through challenging periods as you grow and face competition. This means it covers all the initial and ongoing expenses until your revenue exceeds your costs.
Key aspects of Launch Capital include:
1. Startup Expenses: Initial one-time costs like setting up your office, purchasing equipment, and legal fees.
2. Operational Losses: Regular expenses such as payroll, rent, utilities, and marketing efforts that need funding when you’re not yet profitable.
3. Growth and Competition: Additional funds required as the business expands or when responding to market competition.
Fund & Operate With Capital
Mastering business capital is a critical stepladder to sustainable growth and long-term financial viability. Securing capital to get started from either yourself, friends & family or from sweat equity is just the beginning.
Optimizing the four types of essential capitals—Trade, Infrastructure, Buffer, and Launch Capital—are each crucial steps along this exciting journey. With the insights shared in this blog post, based on Greg Crabtree’s extensive experience and straightforward approach, you are now better equipped to navigate the complexities of capital management.
Embrace the opportunity to deepen your financial mastery and apply these strategies directly to your business. Explore Greg Crabtree’s books for more detailed guidance, participate in his workshops for personalized insights, or engage directly with his consulting services to tailor a financial strategy that suits your unique business needs.
