OCEAN CITY — In 2011, Americans created an average of 543,000 new businesses each month for an annual total of roughly 6.5 million, according to the Kauffman Index of Entrepreneurial Activity, a leading indicator of new business creation in the U.S. Despite a slow recovery, that was among the highest annual number of entrepreneurial ventures founded within the past 16 years.
Equally remarkable is that most young companies are started with nothing more than grit and personal savings, investments from family and friends, and home equity or mortgage refinancing. No matter how brilliant your business plan, lenders typically won’t extend a small-business loan until a company has at least a two-year track record and consistent cash flow. But self-funding a startup has its advantages.
“When you’re starting out, your cash flow will be highly unpredictable, and you may not want to be locked into an inflexible loan payment every month,” says Jonathan Dowst, Small Business Credit Products executive at Bank of America. “Once you’re confident that your cash flow can cover your expenses and debt, it’s time to seek a loan.”
Starting a business shouldn’t involve betting the farm, however. Before you launch that next great idea, consider the following.
Known for their optimism and penchant for taking risks, entrepreneurs usually want to put everything they own into their businesses. But it’s also a fact that most small businesses fail. You’ll need assets to live on until your business turns a profit — as well as a financial cushion to fall back on if things don’t go according to plan. Set aside two years’ worth of living expenses at a minimum, and maintain an emergency fund for unexpected big-ticket personal expenses. And don’t borrow against anything you can’t afford to lose, such as your retirement savings or your kids’ college savings; there are often tax consequences as well as penalties for tapping such funds.
In addition, never mix personal assets with the money you’ve earmarked for your business. Otherwise it’ll be difficult to keep track of your money, or to make decisions about whether to increase your investment or to put the business on hold.
The amount of capital you’ll need depends on the type of business you’re starting. New entrepreneurs are often overly optimistic in their cash flow analysis and can be surprised by unexpected expenses, regulatory costs, attorney fees and construction costs. Experts advise overestimating your startup costs by 30% to 50%. Also make sure you’ve verified your financial assumptions. “It’s harder to fool yourself if you’ve actually talked to people who might be your customers and suppliers,” Dowst says. “Can you really find space that serves your needs for $1,000 per month? Have 20 people said they’d pay $100 for your product as you’ve designed it? Will your competitors respond by dropping their prices?”
Instead of liquidating assets, consider using a line of credit.
Between startup and success, there may be other ways to find cash. “Angel investors often invest in the entrepreneur herself and are willing to take the risk that the proof of concept, customer base and revenue stream will come,” Koplovitz says. Typically with investments of $100,000 to $1 million and an equity position in the company, angel investors will shepherd a startup to a growth stage that will entice first-round venture capitalists to invest larger amounts in the company, generally between $1 million and $5 million.
One of the biggest challenges for a small-business owner is to manage and maximize cash flow. In fact, 45% of the respondents in a Bank of America Small Business Owner Report, a survey of 1,003 small-business owners across the country, said not being paid on time was their biggest impediment to cash flow.
“Helping small-business owners with a cash management strategy specific to their needs enables them to do more with the resources they have,” says Anna Colton, National Small Business Sales executive at Bank of America. A small-business banker can help you accelerate collections with online invoicing and establish electronic payments to vendors. That allows you to better control cash flow by choosing payment delivery time and taking advantage of discounts for timely payments.
A credit card can also be a good way to manage your day-to-day cash flow, provided you pay off the balance each month. “If you pay off those balances and your credit card gives you 3% cash back, you’ve just improved your margins,” Colton says.
Startups don’t become successful businesses without considerable hard work and passion, and entrepreneurs usually possess those qualities in abundance. But you don’t have to face the many challenges you’ll encounter alone. “It can help to have a cadre of professionals who can give you coaching and watch out for you,” Colton says. Of course, it also important to consult your personal advisors for legal and tax advice when considering a new entrepreneurial venture.
(The writer is a senior financial advisor and can be reached at 410-213-8520.)