Top 3 Most Important Financial Factors When Starting a Small Business
Updated: May 4, 2019
One of the most important, yet overlooked steps in starting a small business is evaluating your financial readiness. In this post we'll discuss three key financial factors to making that decision.
Making the Leap
The decision to start your own small business is often a nerve-wracking one. For some, it's the next logical step and one they have been waiting for. However, for countless others, it's a difficult process filled with uncertainty and doubt.
Needless to say, the decision to start your own business cannot be one of pure emotion or pure desperation. Just as a good investment broker would't jump into a stock they have never heard of, you shouldn't start a business without being financially prepared for what's to come. In many ways the decision to start your own business will be the very first business decision you make as a new entrepreneur, and therefore needs to be a well planned investment decision.
All too often, new entrepreneurs in pursuit of that "be my own boss" mentality, make what equates to fatal mistakes for their businesses. Sometimes it's due to a lack of planning or experience, other times it's due to poor timing or a poor product, but most often, the fatal mistake for a small business is a financial one.
Here are some cold hard stats, according to Score.org, the nationally renown small business resource.
Only 19% of businesses that fail, fail due to being out-competed.
23% of business owners report that the business failed because they didn't have the right team.
42% report that their business failed because there was no market for their product or service.
An overwhelming, 82% of business owners report that cash flow and financial problems were the cause of their business failure.
So there you have it. The likelihood of your business failing is 4x greater if you don't have your finances in great shape, but what does that really mean? What does it mean to be financially ready to start your own business?
Avoiding Financial Disaster
We've identified 3 important financial factors that can make or break your new business. These are the analysis and availability of startup capital, the existence of a personal and business emergency fund, and the cash flow plan.
While you may look at these factors and think to yourself that they're no-brainers, let's not forget that 82% of businesses that failed for these very reasons. Let's dive in and explore some of these factors in more detail.
The majority of small businesses start as a micro businesses - meaning its the business owner in a spare room in their house, or a garage doing something they know how to do, or love to do. Some of the most successful businesses in the world have been started this way, and there's no reason that with careful planning, and wise financial decisions, you couldn't do the same.
The first most overlooked factor to starting your own business is having enough startup capital. You'll almost always need more than you anticipate, and once you're rolling you can't put your foot on the brake of your business to collect more money, or find more capital.
Ask yourself this question, but be honest. Do I have the money to start this business? If the answer is not immediately evident, then you have some additional questions to answer. Ask yourself, how much money do I really need to start this venture? Can I prove my business model on a shoe-string budget before going all out? What's that number? $1000? $100,000? $1,000,000? Whatever dollar amount you come up with when you ask yourself these questions, add between 30%-50%, you'll almost always need it. Now, ask yourself, is this amount immediately available to me and will I be jeopardizing anything if I use it? If your solution is to empty your 401k to fund your new business, go back to the drawing board and try again. If you're thinking of taking out a loan, go back to the drawing board and try again.
As billionaire entrepreneur and investor, Mark Cuban stated on one of the episodes of shark tank, "Only morons start a business on a loan". You don't want to put yourself, your home, or your family into the financial cross-hairs of the big banks or investors. Especially without having proven your concept and that you can be profitable. The best thing to do is to find a way to start as lean as possible to avoid loans and avoid putting your personal financial well-being in jeopardy.
Carefully calculate a dollar amount that you think is a good solid figure for how much it will take to get your business up and running, then add 30-50%. Don't start your business, without having this capital in place and don't turn to the bank or your 401k to get loans to help you fund your business.
Personal Financial Stability
If you're currently employed and you've been living off of a steady income, how will starting a small business impact your ability to pay your bills? Evaluate the second factor of your financial readiness by asking yourself: How will I start or run my business while minimizing my personal financial risk?
The correct answer to this question is to always have an emergency fund, both personal and business. As Dave Ramsey teaches in his baby steps, your personal emergency fund must contain 3-6 months of expenses. If your plan is to eventually have your business be your full time gig, then I strongly urge you to have 6 months of expenses in your emergency fund. If your business is going to cater to a niche market or be something few have ever seen before, you'll need 6 months expenses in your business emergency fund as well.
Now that the emergency funds have been established, LEAVE THEM ALONE!
Your emergency fund is not a personal piggy bank. No, you can't dip your hand into the emergency fund when you need to buy some supplies or materials. No, you can't use the emergency fund to take your clients out to lunch. Your personal emergency fund is there for your personal financial emergencies. Meaning, if you get laid off during this process, or you have an unexpected home expense, or a medical emergency, that's when you use the personal emergency fund. It gives you a cushion and doesn't jeopardize the business and open you to financial risk. Pulling money out of your business account to use for personal medical expenses, for example, is a bad idea. You will be taxed on that money and the business will feel the lack of funds.
On the other side of the coin, the business emergency fund is used for business emergencies. Now, the goal here is to plan well in advance and have the capital to never have to use the emergency fund, but as we all know the best laid plans seldom survive first contact. Once again, this fund should consist of 3-6 months of business expenses and is for unforeseen, yet absolutely necessary expenses. For example, you're preparing a new client presentation and your computer dies. This late in the game there's no shop that can get it fixed fast enough. Sounds like a real business emergency. Enter the emergency fund. You draw $1500 and go buy a new computer without a second thought. You'll obviously need to replenish the fund as soon as possible, but for now it's allowed you to keep moving without really skipping a beat.
Establish your personal emergency fund of 3-6 months of expenses first, then concentrate on establishing a business emergency fund of 3-6 months of business expenses. Once these are fully funded, you're protected and ready for the final step.
The Cash Flow Plan
Perhaps the most challenging of the three financial readiness factors is the cash flow plan. After all, how can you predict your cash flow when you haven't even opened your doors, so to say?
The answer is research. Do your due diligence. If you've been in this business or industry and have some experience, then you're slightly ahead of the game. You should at least have a rough idea of your expected income/profits and your expected expenses as well, but, running your own business is a whole different beast, so keep that in mind.
You'll need to be conservative with your numbers at first. So when you're considering how many clients you will start out with, always plan for less. Even if they've verbally committed to you that they will work with your new company and be your customer, plan otherwise. If you've gotten the nod from 5 clients, plan for 2 or 3 actually following through. This will help you establish a much more realistic income for your new business.
On the expense side, you'll need to carefully create a business budget. This is where your startup capital and emergency fund will come in handy. What was that number you decided was required to open your business? Did you add 30-50%?
Your expenses will almost always be higher than anticipated. From processing fees to rent, there's a lot of room for error. Do you best to budget for everything you can think of, then adjust the budget as you start your business, and continue to monitor it as you operate.
Your cashflow plan will be directly impacted by your ability to accurately document your business income and expenses. So be conservative on your income and thorough on your expenses. You can also read this great article on business cashflow from the balance.
Starting your own small business can be a very rewarding experience. You may have heard people referring to their businesses as their baby. That's because there are indeed many similarities. Your own business can be the best experience of your life, however it can also be the most trying, frustrating and stressful experience of your life as well.
With careful planning and the three financial readiness factors, you can turn a nerve-wracking experience into the best decision of your life.
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