Over the next couple of days we are going to finish up our series by discussing how to determine your initial investment needs and the management structure of the entities we have discussed.
Now that we have at least a small base of understanding of the tax structure for the entities we are discussing, let’s get a little deeper into why some of these tax issues matter. That is the issue of capitalizing your business (or determining how much money you need to get started).
The first year financials of any business are always important. Technically, this isn’t my purview, but it is important to look at how the business cash flow looks to figure out how to fund the business before you get started. You need to plan your cash flows to make sure everything works properly.
In business, this is often looked at in quarters of the year. A quarter is technically 13 weeks (That is 1/4 of 52 weeks, not 3 months). The reason is that cash flows in weeks, not in months. So, as you are building your cash flows for the year (or for the project), what do they typically look like. Let’s play with a cash flow model. To begin, you want to start with a model that looks like this:
This is obviously an example and as we go through the numbers, they are not truly representative of what you must see, but they are used to show how to properly plan for the capital investment you need in your company.
There are expenses in a company on day one. Typically, to build a rolling 12-week cash flow model, you would start with your expenses. You need to include everything that you might possibly need to pay for in the first 12 weeks of the business. So, you will see a cash flow that looks like this.
Notice, you have a negative amount of money. This is normal. We are reverse engineering your starting capital needs, so you should see this for at the beginning of the process. The rule of thumb is, if you expect an expense to be in a certain range, you choose the higher number. So, if you expect an expense to be between $100-$200, you include $200 in the expense column. Notice I have added a few often neglected expenses into this cash flow.
I have also showed in the cash flow, that it may take some time before you are actually open and ready to begin. Too often people neglect to plan for the initial stages of the business before any patients have been seen or invoices submitted.
Once you have come up with every possible expense, you then need to look honestly at the money you will be bringing in. The reverse of what I said about expenses is true for income, if you expect income to be in a certain range, you choose the lower number. You must run cash flow models as conservatively as possible. A potential beginning cash flow may look like this.
Now, in this cash flow, I have used some fairly conservative numbers, but I have also left out a number of the expenses that you may encounter in a health care business (equipment and technology expenses come to mind). Now, notice that you are still losing money. You are cash flow negative. This is expected. Rarely can a business start for $0 and survive. Also notice, you are not making money for a month. This assumes you can completely build out your building in one month. Notice, you don’t even see Medicare reimbursement on these numbers. The reason for this is that Medicare can often take 90 days or more to reimburse (especially the first time).
The idea is for cash to be available at all times. So, let’s look at our example to determine how we need to capitalize this company. If you look at the first week in April you will see your low cash point. The low cash point is $38,272. That means, before you begin to see an improvement in your cash position, you will dip to at least $38,272. This is how you determine the amount of money needed to place into the company to begin.
You always need to make sure you include enough money for reserves. Typical reserves estimates are between 10% and 100% of the lowest cash point. That depends on the accuracy of your estimates. Especially if you are building out or you are making any other large purchase to get started. There will always be hidden expenses. And remember, you may not be entirely accurate in your income. What happens if it takes you an extra week to open. An extra two weeks. Are you adequately prepared?
So, using our example, how much money do you think we should invest into the company?
In this example, I added 50% ($57,408) of the low point and rounded up. 100% may seem a bit high, but 50% will allow for adequate capital overages. This allows almost double the money allotted for the building budget and should be enough to make the company solvent.
Now, why does this matter?
It matters because if you don’t make sure you have put enough money into the company to allow it to properly make money on its own, you may destroy the limited liability protection the entity you selected was designed to give the owners.
Inadequate capitalization is a major problem. If your business fails 4 months or 1 year down the road, the creditors will start by looking at the capitalization of the business before they just let the business go. If you put in enough money and your business failed (which happens) because you couldn’t make enough money or it was not the right time, that is one thing. But, if your business fails because you failed to put in enough money on the front end, you may be in trouble. It all comes back to limited liability.
Now, take this into account when you consider debt versus equity and how you should try to take the investment into your business and how it will impact your cash flow. Keep in mind, if you take debt, it will impact your expenses because you will have to pay back the debt. So, make sure to take that into consideration when planning your initial cash flows.
Want the cashflows used in these examples? Download the file you need to help you get started with your rolling cashflow!