What Is Capitalization of a Start-Up?

Definition

Capitalization is the initial investment or seed money for a start-up that allows the business to launch and stay operational. It's often the investment made by the business owner, money borrowed from lenders, and funds from any other investors in the firm.

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Key Takeaways

  • Capitalization refers to raising funds for the operation and growth of the business.
  • There are two main ways to raise capital: equity funding and debt funding.
  • Bank loans are typically the most common and the largest source of capital for small businesses.

How Start-Up Capitalization for Small Business Works

The term "capitalization" refers to raising funds for the operation and growth of the business. It can be used to:

  • Pay for assets such as equipment, vehicles, and real estate
  • Fund growth by purchasing inventory, hiring employees, financing receivables, and more
  • Build a fund for emergency expenses       

Each small business has its own way of raising funds as we’ll see below, but most of them use a combination of different funding methods. Early-stage start-ups typically fund their business out of pocket or borrow money from family and friends. 

Once they have a viable business plan, start-ups can open their doors to obtain loans or invite external investors. 

Note

Friends and family members can also become investors in your business if they buy equity or shares in your company. 

Types of Small Business Capital

There are two main ways to raise capital: equity funding and debt funding. Capitalization can include both equity and debt, although companies typically prefer keeping debt to a minimum.

Equity Funding

Investors are financially secure individuals who buy shares or ownership in your company in exchange for money. In addition to monetary funding, equity investors may be experts in your field and provide valuable business advice. 

Unfortunately, in this model, you don’t retain full control over your business and may have to make decisions based on your investors’ inputs. In some cases, equity investors may also be entitled to a portion of profits.

The benefit is that you don’t have any monthly repayments and no high interest rates to worry about. You also benefit from the investors’ business experience and solid advice, especially if you’re new in your industry. 

Debt Funding

Debt is a loan issued to your company. You retain all shares of the company, but you have to pay back the money loaned to you, along with interest.

However, regular and timely repayment of the loan can build business credit, which will enable you to take bigger loans in the future, if required. Moreover, you can also deduct interest payments on your business income tax return.

Where To Find Start-Up Capital for Your Small Business

Finding the start-up capital for your small business begins with identifying your business goals. Where do you want to be in the next few months and years? What are your financial goals and predictions? 

Outlining these goals can help you find the right options to raise capital. For example, ask yourself if your business needs quick cash and control over how to spend it, or if it would be better to get some advice on how to get the most bang for your buck. 

If you need money and control, you can look at loans, while if you’re okay with giving away a part of your ownership in exchange for funds and guidance, equity funding may be the right option for you. 

Once you’ve figured that out, you can start applying for loans or open your company to investments. 

Note

Important: If you want to pursue investors, your business plan will have to show substantial growth within three to five years so the investors have a viable exit strategy.

Frequently Asked Questions (FAQs)

What is the largest source of capital for a small business?

Bank loans are typically the most common and the largest sources of capital for small businesses. With various types of lenders and repayment options available to pick from, businesses can have the flexibility and a constant flow of cash while retaining control over their company. 

What is considered a small business?

The Small Business Administration defines a small business as a sole proprietorship, partnership, or corporation that is “not dominant in its field on a national basis.” Whether your business classifies as a small business varies by the industry you operate in and depends on the “average number of employees over the past 12 months or average annual receipts over the past three years.” Typically, small businesses have fewer than 1,500 employees and generate less than $40 million in revenue.

Updated by
Sakshi Udavant
Sakshi Udavant headshot
Sakshi Udavant covers small business finance, entrepreneurship, and startup topics for The Balance. For over a decade, she has been a freelance journalist and marketing writer specializing in covering business, finance, technology. Her work has also been featured in publications and media outlets including Business Insider, Chicago Tribune, The Independent, and Digital Privacy News.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. U.S. Senate Committee on Small Business & Entrepreneurship. “Access to Capital.”

  2. Library of Congress Research Guides: “Types of Financing.”

  3. Accion Opportunity Fund. “What Investors Look for Before Investing in a Small Business.”

  4. Iowa State University: Extension and Outreach. ”Types and Sources of Financing for Start-Up Businesses.”

  5. Internal Revenue Service. “Topic No. 505 Interest Expense.”

  6. Small Business Administration. “Fund Your Business.”

  7. FDIC. “2018 Small Business Lending Survey.”

  8. Small Business Administration. “Does Your Small Business Qualify?

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