Blasingame’s 3rd Law of Small Business states, “Its redundant to say ‘undercapitalized small business.’”

There are two primary reasons this Law is true:

1. Unlike big businesses, small businesses typically have only three sources of capital: a) retained earnings (profits left in the business); b) direct investment, usually by the founder; and c) debt, usually from a bank.

2. Everyday one or more elements of a small business are screaming for funds to increase the company’s competitive advantage.

Even very successful small businesses are undercapitalized. In fact, ironically, the more successful a small business is, the more undercapitalized it will likely be. If a business is not growing, it needs capital to achieve growth. A growing business needs capital for R&D, upgrading technology, acquiring new product lines, funding accounts receivable and inventory that increase with sales growth – the list is long.

For most small businesses, the lion’s share of capital comes from retained earnings and bank debt. However, other than the founder’s investment, direct equity capital is less likely. But when outside equity is acquired, the next most likely source is from angel investors, which has become an increasing direct investment option over the past few years.

An angel investor is typically an individual who has money to invest and, instead of putting all of it in the stock market, he or she will allocate a portion to invest directly into a business, which could be either a start-up or a going concern. More recently, angel investors have formed regional consortiums to aggregate their investment dollars in order to spread the risk and make sure that they don’t make the mistake of under-funding a venture.

Most people have heard of venture capitalists (VC), the big dogs of entrepreneurial investment. Angels are sort of mini-VCs. The big difference is the level of funding and, in many cases, the closeness of the relationship with management; angels will be more likely to be geographically and emotionally closer to their recipient than a VC. The big similarity is that both anticipate an exit strategy where their capital – and hopefully a profit – are returned. This last point is the primary reason why most small businesses are not candidates for any investor capital, since the typical small business founder expects to run his or her business forever and perhaps hand it off to the next generation.

Recently, on my small business radio program, The Small Business Advocate Show, I talked about how angel investors choose investment candidates with Tim Berry. Tim is the world’s leading expert on business planning, founder of Palo Alto Software, an original member of my Brain Trust and my good friend. Tim is not only an angel investor, he is a member of one of those angel consortiums mentioned earlier. Take a few minutes to listen to what Tim told me about his experience and this fascinating process.