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Blogs by William Manchee
5. Defending the Small Business: Starting on A Shoe String
10/15/2008 5:59:28 PM
Under-capitalization is one of the most common causes of small business failure yet small business owners routinely set up shop with no where near enough capital to have a reasonable chance of success.
As mentioned earlier, under-capitalization is a major cause of small business failure, particularly with so many chain stores and franchise operations muscling their way into almost every neighborhood. For some service businesses like a small law firm, insurance agency, realtor, or small accounting firm, capital isn't as critical as it is in other businesses. Some businesses, such as printers, small manufacturers, wholesalers, or auto repair shops require extensive furniture, equipment and inventory. For the latter, starting with adequate capitalization is critical for their survival.
Today I have two clients in the wholesale distribution business who are both quite successful—JB Gift Distributors and Addison Electric. But their success came only after first failing because they were inadequately capitalized. Both owners had learned their trade while working for other similar companies. After a while they believed they had the expertise to run their own companies, so they ventured out by themselves. Lacking capital they borrowed heavily to purchase the large inventories they needed to start business. This was the mid-80s just before the economy collapsed. At first they did well, but when the savings and loan crisis hit, only to be followed by a recession, they were caught short of capital. One of the banks called in JB's loan and Addison got way behind with vendors and the IRS. Both companies ended up in bankruptcy, one in Chapter 7 and the other in Chapter 11.
JB filed Chapter 11 in the fall. Fortunately most of its debts were to suppliers and the IRS rather than large banks or financial institutions, which are much harder to deal with because they are secured creditors and have greater rights than priority or unsecured creditors. The only complication was a creditor's committee that was led by the largest unsecured creditor, a supplier who would take a big hit if the plan were confirmed as proposed. The creditor opposed nearly everything we did, but eventually realized that getting something was better than nothing. We settled by agreeing to pay twenty-five cents on the dollar rather than ten percent we initially proposed. By the next summer, its plan was confirmed and JP came out of bankruptcy. It was successful only because seventy-five percent of its debt was eliminated in the reorganization, overhead was slashed, and the government and secured creditors were forced to restructure the debts owed them and accept a long-term payout.
Addison Electric started over. They owed a large sum to a bank and were way behind in lease payments, but had kept their suppliers paid. This would have made a Chapter 11 difficult because the bank and the landlord would have required payment in full, and they wouldn't have to agree to a long-term payout. So the owner of Addison Electric, a high-roller with a high maintenance wife, started over this time with a lot more capital, less overhead, and the knowledge learned from his first venture into the small business arena.
He vowed not to make the same mistakes he had made the first time around and, with his client base intact, took off fast without much capitalization. Today he calls on me for estate and tax planning issues more than anything else. His business is growing rapidly and now is worth millions. But he was only able to launch his new distribution business because he had a client base established. He was lucky in this regard, because an astute Chapter 7 trustee would have recognized the value of his client base and tried to sell it rather than abandoning it to the SBO debtor. Fortunately for him, most Chapter 7 trustees are so busy and overburdened that they rarely go after an intangible asset like goodwill. They tend to focus on hard assets like vehicles, inventory, equipment, and accounts receivable. In this case, the trustee never even considered the most valuable asset of all, a list of over five hundred active clients who ordered electrical parts and supplies almost every week.
So why do entrepreneurs start a business when they know that they don't have enough capital? Is it overconfidence, unrealistic optimism, or stupidity? My observation is that it is all of the above, plus a denial of reality. I remember when I got out of college and started looking for a job, how helpless and frustrated I felt going from one prospective employer to another trying to sell myself and land a job. It was demeaning, humiliating, and I hated it. It wasn't long before I vowed to own my own business so I didn't have to kiss anyone's ass. When I got out of law school, I didn't even apply for a job with a big law firm, because I didn't want to have to interview and beg for a position. Once the seeds of independence are sown, nothing can stop them from growing into an independent spirit.
I didn't realize it until years later, but my life was predestined by my parents and my circumstances when I was a child. Being a little overweight and introverted like my father, I didn't have a lot of friends and never learned to socialize very well. My self-esteem was pretty low, and it wasn't until high school that I discovered I wasn't as dumb as everybody thought. I'm not sure exactly what triggered this realization, but it was too late as my shy, introverted personality had already set and couldn't be easily changed.
Because Mr. Popularity, I wasn't, I had to learn to be independent and self-motivated. In the short run it was pretty depressing as I envied all the popular, socially skilled kids that got all the attention and respect. In later years I was glad I had learned to survive on my own without depending on others—particularly as clients paraded through my office every day, the victims of corporate maneuvering or indiscretions.
If being an entrepreneur is a conscious choice, as I am sure it is for some, the reasons for being independent are many. Some see it as the only way to have a chance at becoming rich and famous. Why work to make someone else wealthy, I often hear them say. Others have great dreams and aspirations that they feel will never be obtained if someone else controls their destiny. These entrepreneurs often become obsessed with making their dreams a reality, so that they often overlook or ignore the obvious risks and pitfalls that lay before them. They simply don't care about reality. In their minds somehow they will overcome the odds and achieve success. It's a tragic case of self-deception. So many entrepreneurs start off their new businesses keenly aware that they are grossly under-capitalized, but believing firmly that somehow they will survive and be successful.
Next - Giving It Away
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• Defending the Small Business: Part 17 - Bankruptcy: Friend or Foe? - Monday, December 29, 2008
• Tarizon: The Liberator Launch Update - Friday, December 26, 2008
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• 6 - Defending the Small Business - Giving it away. - Thursday, October 16, 2008
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• Understanding the Current Economic Meltdown - Saturday, October 11, 2008
• 2 - Defending the Small Business - Doomed From Day One - Saturday, October 11, 2008
• 1 - Defending the Small Business: Introduction - Friday, October 10, 2008
• The Stan Turner Mysteries - Sunday, March 25, 2007
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