Starting A Small Business
By Amy Fontinelle http://www.investopedia.com/university/small-business/default.asp Thank you very much for downloading the printable version of this tutorial. As always, we welcome any feedback or suggestions. http://www.investopedia.com/contact.aspx
Table of Contents 1) Introduction 2) Choosing Your Business 3) Financing Your Business 4) Business Structures 5) Making The Leap 6) Location And Licenses 7) Hiring Employees 8) Taxes 9) Record Keeping 10) Conclusion
Introduction
Why do people start a small business? Some want to spend more time with family, and starting a business allows them to do that. Some find it exhausting to be outside the house all day, dealing with traffic, co-workers, meetings and interruptions. Some people hate answering to a boss all the time- needing permission to schedule a dentist appointment or take the day off when they're sick. Some people are unmotivated by the security of a regular paycheck and prefer the challenge of the direct rewards or losses that entrepreneurs see from their efforts. Maybe you want to build an empire and become famous, or create a wealth-generation machine that you can pass on to your children. Or perhaps you can't convince anyone to recognize your unique vision and you've decided that it will never come to fruition unless you strike out on your own. Or maybe you're thinking of self-employment because you've been unemployed for so long that you feel that you've exhausted all the other options.
Becoming a small business owner has unique challenges and rewards that aren't right for everyone. You must be driven, disciplined and able to identify a product or service that people need - one that they will pay enough for to allow you to live comfortably. You have to develop marketing skills and be able to find your own work, because it won't fall into your lap until after you're well established. Business owners need to understand how to budget, keep records and handle small business taxes. They must familiarize themselves with employment laws if they want to hire staff. They also need a plan for protecting their business and everything that's tied to it if something goes wrong. (For more, see Are You An Entrepreneur?) In this tutorial on starting a small business, we'll address all these issues and more.
small businesses are home businesses. Becoming a consultant might require you to attend lots of meetings and travel frequently. Open a boutique and you'll spend most of your waking hours at your store, at least initially. (For more, read Start Your Own Small Business.) Once you figure out want you want to do for a business, it's time to figure out how you will afford it.
Starting A Small Business: Financing Your Business
No matter what line of business you go into, you will need startup capital to get your business going. Some typical startup costs facing new business owners include: Electronic equipment: computer, printer, scanner, fax machine, photocopier, etc. Vehicle Furniture and fixtures: desk, lamps, bookshelves Office supplies Reference books Supplies/inventory Manufacturing machinery and equipment Advertising: domain name, domain hosting, mailers, website design, etc. Operating Space Licenses Permits Corporation fees Legal fees Security deposit for renting a business location What you need to buy can also depend on the degree to which you want to separate your business from your personal life. Many people will use their personal vehicle, cell phone and a room in their home to meet these needs inexpensively. Incorporating to separate your business assets and liabilities from your personal ones also costs money, but it offers an extra layer of protection if your business fails. You should also consider operating costs that you'll pay regularly in the course of running your business. Some of these may be required before you set up shop and on an ongoing basis thereafter, like insurance, membership fees and dues, loan payments and employee wages. Sources of Startup Capital How much money you can afford to risk on your business from your personal savings and how much money you need to open for business will determine whether you need to look elsewhere to raise startup capital. Let's consider the pros and cons of each potential money source.
Personal Savings Personal savings are commonly used by business owners to help pay for startup costs. You won't incur any interest expense when you use your own money to finance your business. You also won't have any creditors to pay back, and no one will come after you for money if your business fails or isn't successful right away. On the other hand, most people have already earmarked their personal savings for other uses, like retirement and a rainy day fund. Unless you already have plenty of extra money lying around, you might want to start setting aside some of your savings each month to put toward your business. You might also be able to tap your home equity, but it's a big risk to tie the success of your business up with having a place to live. Business Loans Banks provide business loans to finance vehicles, equipment, real estate and other expenses. These loans are generally for a short term, such as six to seven years, but the duration can often vary based on the type of financing required. Some type of collateral generally must be used to secure the loan - usually the vehicle, equipment or real estate being purchased with the loan, or a blanket lien on other assets. Expect to pay a loan origination fee and, of course, interest. Business loans can offer the security of a fixed monthly payment and a fixed interest rate, although variable rate loans may also be available. (Not sure what sort of loan you should get? Read Which is better, a fixed or variable rate loan?) Some banks may only offer loans on large amounts; if you need to borrow less than the minimum requirement, seek other financial institutions to provide a more accommodating loan or dip into your personal finances. You might also want to finance your equipment and vehicle needs with a line of credit or a conditional sales agreement. If you plan to seek a loan from a bank, be prepared to provide a detailed explanation of how much money you need and for what purposes, as well as a detailed explanation of how you will be able to repay the loan. The bank may want to see recent personal income tax returns, bank statements, credit history and other personal financial information. Small Business Administration Loans Small Business Administration (SBA) loans are an option if you don't qualify for a regular business loan. Your business must be owner-operated, for profit, organized as a sole proprietorship, corporation or professional partnership, and fall within the size guidelines set by the SBA. Because these loans are guaranteed by the government, they can be easier to qualify for than conventional business loans. They also allow you to make lower payments over a longer period of time. Although SBA loans are provided through regular banks, the government simply acts as the guarantor. Special SBA loans are available for veterans, active duty military, reservists, National Guard members and the spouses of people in these groups.
limits the entrepreneur's upside potential since venture capitalists will often require majority ownership of the business. On the other hand, the majority of the downside risks are also assumed by the lending party. (For more insight, read When Your Business Needs Money: Angel Investors.) How Much Capital Do You Need? There is no one-size-fits-all method for determining startup capital needs because each business has unique requirements. Basically, you need to make a list of the startup items specific to your business and research each one to determine its cost. It's important to actually do the research, and not just guess - especially if you are doing this for the first time. If you rely on hunches, you may grossly under- or overestimate your expenses. Also, if you're seeking financing, the lender will be hesitant and may not take you seriously if your numbers aren't realistic and well-researched. When you're starting a business, there are a couple of ways to get carried away with spending money. First, you may be overemphasizing about the tax deductibility of business expenses. While tax breaks will reduce your costs, they won't make your purchases free. You'll still be paying for the bulk of everything yourself, so you shouldn't buy it if it isn't necessary. Second, you may be so excited about starting a business that you have trouble differentiating necessary expenses from optional ones. Do you really need a brand-new, solid wood desk, or will that card table in the garage get the job done just as well? Remember, initially the most important thing is keeping your business afloat so you can earn a profit. Every purchase you make should be directly related to this goal. Minimizing what you need to buy and how much each item costs will help you meet this goal. You want to get by on as little startup capital as possible. (Don't overlook the details when starting up a business. It's the small expenses that have the potential to make or break a great idea. For more information, refer to Business Startup Costs: It's In The Details.)
Next, we'll talk about protecting your business by choosing a legal structure and purchasing insurance.
organization, with your state. Depending on your state's laws and your business's needs, you may also need to create an LLC operating agreement that spells out each owner's percentage interest in the business, responsibilities and voting power, as well as how profits and losses will be shared and what happens if an owner wants to sell her interest in the business. You may also have to publish a notice in your local newspaper stating that you are forming an LLC. Corporation Like the LLC, the corporate structure distinguishes the business entity from its owner and can reduce liability. However, it is considered more complicated to run a corporation because of tax, accounting, record keeping and paperwork requirements. Unless you want to have shareholders or your potential clients will only do business with a corporation, it may not be logical to establish your business as a corporation from the start - an LLC may be a better choice. The steps for establishing a corporation are very similar to the steps for establishing an LLC. You will need to choose a business name, appoint directors, file paperwork (articles of incorporation), pay filing fees and follow any other specific state/national requirements. (Find out how becoming a corporation can protect and further your finances. See Should You Incorporate Your Business?) There are two types of corporations: C corporations and S corporations. C corporations are considered separate taxpaying entities. They file their own income tax returns, and income earned remains in the corporation until it is paid as a salary or wages to the corporation's officers and employees. Corporate income is often taxed at lower rates than personal income, so you can save money on taxes by leaving money in the corporation. If you're only making enough to get by, however, this won't help you because you'll need to pay almost all of the corporation's earnings to yourself. If the corporation has shareholders, corporate earnings become subject to double taxation in the sense that income earned by the corporation is taxed, and dividends distributed to shareholders are also taxed. However, if you are a one-person corporation, you don't have to worry about double taxation. S corporations are pass-through entities, meaning that their income, losses, deductions and credit pass through the company and become the direct responsibility of the company's shareholders. The shareholders report these items on their personal income tax returns. S corps thus avoid the double taxation on income that is associated with C corps. All shareholders must sign IRS form 2553 to make the business an S corp for tax purposes. The IRS also requires S corps to meet the following requirements:
Be a domestic corporation Have only allowable shareholders, including individuals, certain trusts and estates Not include partnerships, corporations or non-resident alien shareholders Have no more than 100 shareholders Have one class of stock Not be an ineligible corporation (i.e., certain financial institutions, insurance companies and domestic international sales corporations)
you from legal fees and judgments if your business is sued. Here are some of the basic policies and their purpose:
General liability insurance protects you from injury claims, property damage claims and advertising claims. Professionals such as doctors, lawyers and consultants need professional liability insurance to protect them from errors and omissions, including malpractice and negligence. If you are going to manufacture or sell products, you will want product liability insurance in case someone is injured by your product. If you will have a business location that customers or clients will be visiting, you will certainly want to make sure you are covered for claims of personal injury on your property. If your business has employees, you can purchase employment practices liability insurance to protect yourself against claims of harassment, discrimination and wrongful termination. You will also want insurance that protects your business from any liability your employees may incur.
Whatever line of business you are entering, there is probably an insurance product that will cover you. For example, there are specialty business insurance products designed for architects, engineers, accountants, dentists and technology service providers (among others). (For further reading, check out Insurance Coverage: A Business Necessity.) Next, we'll discuss how to transition from your current job to self-employment.
Starting A Small Business: Making The Leap
Often, the best way to strike out on your own is to do it gradually. This reduces the risk that you'll be without an income and allows you to test the waters and see how much potential your business idea has before you give up your regular paycheck. If you're currently employed full time, it may seem impossible to muster up the time or energy to work on a business plan. Hopefully, the excitement you feel for becoming independent will motivate you to use your nights and weekends to get your business up and running. If you can find the time to do the work and it doesn't create a conflict of interest with your existing employment, it's smart to start acquiring clients and customers and providing your product(s) or service(s) to them while you still have your day job. You'll start creating a revenue stream for your business and get an idea of whether your business has the potential to sustain you if it becomes your only source of income. But before you do anything else, you should create a business plan.
Developing a Business Plan Every business should have a business plan, but it doesn't necessarily have to adhere to a specific template. The complexity of the business you're starting, the type of business you're starting and your funding needs will determine what kind of business plan you need. (Find out how to put this important document together in 4 Steps To Creating A Stellar Business Plan.) For a simple business that you will be funding yourself, the purpose of a business plan is not so much to create a formal document as it is to think through the details of how you will make your business a success. You will be much more likely to succeed if you consider every aspect of your business before you jump in. To get started, ask yourself these questions: Basics What will my business name be? What product(s) or service(s) will I provide? What makes me qualified to run this business? Do I need any additional education, training or credentials to be successful? Is there a demand for my product(s) or service(s)? How have I determined that this demand exists? Who are my primary and secondary target customers/clients? How will I get them to purchase my product or service? If I am providing a product, who will my suppliers be? What will my business hours be? Where will my business be located? Will I have any employees? Finances
What will my business expenses be? How much money does my business need to make annually for me to stay in business? What price will I need to charge for my product(s) or service(s) to meet my financial goals? What assets do I already have for my business? What assets do I need to acquire? How much will they cost? What other startup costs will my business incur? How long might it take my business to break even? To turn a profit? Can I afford to wait that long?
(Read 7 Unconventional Ways Businesses Can Borrow Money to find out how your business can get the money it needs - even when the bank says "no.”)
How many hours a week will I need to work for my business to be successful? How many hours a week can I realistically work given my energy level, focus, family commitments and other obligations? How will I balance running a business with my other obligations and activities?
Staying in Business
Who is my competition, and how will I differentiate myself from them to gain market share? How will I market my business? What alternate product(s) or service(s) could I branch out to if my initial ones aren't successful? How will I maintain my business through tough times? How much time or money can I afford to devote to my business in lean times before I have to go back to having a regular job?
paycheck, the fluctuations in income and expenses you'll experience as a small business owner may be shocking. Eight months of the year, you'll pay no taxes, and four months of the year, you'll make large payments. Your income might be $1,000 one month and $10,000 the next month. It all depends on how many sales or assignments you have and when your customers or clients actually pay you. In the month when you bring in $1,000, you'll need to rely on your savings. In the month when you bring in $10,000, you'll need to set aside a lot of that money to handle the next shortfall. Your budget will help you see how your income and expenses are averaging out over time and what kind of profit or loss your business is seeing from month to month and overall. (To learn more about weathering unexpected events, check out Keeping A Small Business Afloat.) You've determined how you will run your business and manage your business's finances. But there are still more steps to take before you're up and running. In the next section, we'll explain how to find a business location and how to obtain the necessary permits and licenses.
Starting A Small Business: Location And Licenses
The type of business you're starting, the laws where you want to open your business, what you can afford and what suits your lifestyle will determine what options you have for your business location. Home Office For many new small business owners, a home office makes the most sense. Most cities and towns will allow you to run a business out of your home as long as you meet certain criteria. Here are some examples of business situations where your city may not allow you to run your business from your home: Clients or customers will be visiting your home The business will be located in your garage You want to manufacture a product on your premises You want to repair vehicles on your premises You will have one or more employees The business will create a noise disturbance The business will occupy a large percentage of your home If you are a renter, you may have additional hurdles to jump through with your landlord. A major benefit of using your home as your business location is that you won't waste any time commuting and you won't incur additional costs to rent an office space. The IRS also offers significant tax deductions for a home office used for your business.
A major drawback of working from home is that you can never truly leave work. Also, many types of businesses aren't suited to a home location. (Learn how having a good work area can contribute to your success in Creating A Home Business Work Space.) Storefront A storefront gives you more than just a place to do business. With the right location and signage, it's also a form of advertising. If you're in the cupcake business, for example, you will likely have more customers if you sell cupcakes from a visible storefront rather than simply providing them for catered events. Of course, you'll have to determine whether the costs and extra work of running a store provide enough of a payoff. Running the store might detract from your catering work, or it might enhance it by bringing you more foot traffic and more potential catering customers. But you'll have additional costs from renting the space, paying utilities, securing additional permits and licenses, dealing with the health department and probably hiring at least one employee to help you attend to customers. A storefront can also make sense for someone selling a service, like an accountant. But you'll have to be prepared to deal with interruptions from walk-in business and, again, be able to afford the extra expense. Office Building If you provide a professional service like consulting, renting a space in an office building might make sense. It will allow clients to come to your office instead of you always having to go to them, and working outside the home means a greater separation between your work and home life. You are unlikely to have interruptions (or extra business) from walk-in customers. Although you will have to spend some time commuting, working outside your home also gives you more opportunities to meet people for networking. Permits, Licenses and Business Registration There are both federal and local requirements for business permits, licenses and registration. The requirements depend on what your business does and where it is located. The only types of businesses that require a federal license are ones that fall under the supervision and regulations of a federal agency. Some of the types of business are listed below:
Aviation Investment advising Drug manufacturing Preparation of meat products Fish and wildlife Mining and drilling
Nuclear energy Radio and television broadcasting Ground transportation Selling alcohol, tobacco, or firearms
These lines of business will also generally require special state licenses. Your state will probably require you to have a business license for tax purposes. Depending on your line of work, you may need a state occupational license. Doctors, attorneys, real estate agents, insurance salesman and hairdressers - among others commonly need an occupational license. If you want your business to sell liquor, lottery tickets, gasoline or firearms, you may need a special state license. If your business will operate under a fictitious name, you will probably need a "doing business as" or DBA permit from your city. You may also need a basic business operation license from your city. Certain businesses, such as manufacturing, require zoning and land use permits. Nightclubs and bars may require fire permits. If you'll be selling taxable merchandise, you'll need a sales tax license/seller's permit. If you'll be preparing or selling food, you'll likely need a health department permit. And yes, almost all of these permits and licenses cost money. Some are flat fees and some are based on your business income, also known as gross receipts. The websites for your state and local government are a good place to find information on the permits, licenses and registration necessary to open and operate your small business. Calling your city hall is another good place to start. Employer Identification Number (EIN) You will need to apply for an employee identification number (EIN), also known as a taxpayer identification number, with the IRS if your business:
Is a corporation or partnership Has employees Files employment, excise, alcohol, firearm or tobacco tax returns Has a Keogh plan (a type of small business retirement plan)
market the restaurant, buy the food, keep the books, do the prep work, cook, wait tables and wash dishes all by yourself. If you have a strong social network, you may be able to convince friends and family members to donate some time to your new business. Think about what you can offer them in return to create a mutually beneficial relationship. Differences Between Employees and Independent Contractors If you're not ready to make a financial or emotional commitment to an employee but you'd like to see how you do with help, consider hiring temporary help, virtual help or an independent contractor/freelancer. In the case of virtual help, depending on your line of business, this person could be a virtual assistant, writer, researcher, website designer - anything you need that can be done remotely. If you want to, you can conduct all of your interactions with this person online and through a third-party company. You can hire someone to fill a temporary need, or you can hire them on a trial basis to see how you like having assistance. Using Temp Agencies If you prefer to work with a real, live person, you can seek out independent contractors and freelancers in your area. Temp agencies are another source of temporary or even permanent help. Just keep in mind that they can be more expensive, as you'll have to pay the temp agency a fee for finding and screening the employee on top of the employee's wages. The nice thing is that the temp agency will be responsible for handling the employee's payroll taxes and benefits. That alone can make the temp agency fee worthwhile. A major benefit of hiring any independent contractor, freelancer, virtual assistant or temporary worker is that you won't be directly responsible for their payroll taxes, unemployment insurance, workers compensation and so on. Either the agency they work for will provide these things or the worker will be personally responsible for them. You do have to be careful not to violate IRS rules regarding independent contractors. If the IRS determines that you're treating someone as an independent contractor for tax purposes when their function is really that of an employee, you'll be responsible for back taxes and fines. Speaking of taxes, that's up next.
Payroll Taxes If you hire even one employee for your small business, or if you structure your business as a C corporation (which makes you an employee), your tax situation becomes much more complicated. You'll have to withhold federal andstate income taxes and FICA (Social Security and Medicare) taxes on behalf of all employees. You'll also have to pay the matching portion of Social Security and Medicare for each employee, and you'll have to fill out additional paperwork and possibly make more frequent tax payments using IRS form 941, Employer's Quarterly Federal Tax Return, as well as the equivalent state form. If your tax liability is high enough, you will have to make payments monthly or semiweekly instead of quarterly. The details of this system are beyond the scope of this tutorial; see IRS Publication 15 (Circular E), Employer's Tax Guide, for more details. If you have employees, you may also be required to pay state unemployment insurance, and your state may require you to pay into a worker's compensation fund. Hiring an Accountant Does this tax stuff have you totally confused? Most people are mystified by their own personal tax returns, let alone the more complex returns required of businesses. If you're not confident in your ability to understand the requirements and correctly prepare returns and calculate payments, it's worth the expense and the trouble to hire an accountant. The time this will save you in dealing with tax issues will free you up to focus on your business. An accountant's expertise will also help you avoid tax penalties, so the expense of hiring this professional can end up paying for itself. (For more see Crunch Numbers To Find The Ideal Accountant and 10 Tax Benefits For The SelfEmployed.) If you don't want to be dependent on an accountant or have to pay their bills forever, you can transition to doing your own taxes by taking some tax preparation classes and/or seeking instruction from your accountant. Even if you hire an accountant, you'll still need to keep meticulous records. In the next section, we'll discuss creating and maintaining business records.
Accounting and Tax Records If your business has complicated financial records or if you want to be able to prepare financial statements with the click of a button, business accounting software like QuickBooks can be a big help. Be warned, though, that to use business accounting software accurately and effectively requires some accounting knowledge. If you don't know whatdebits, credits and journal entries are, this software may just cause you headaches. You can always keep records by hand or by spreadsheet. In many cases, spreadsheet software can serve all of your accounting needs - at least while your business is small. You can even get free spreadsheet software by downloading Open Office, an open-source software suite similar to Microsoft Office. (For more, see Business Startup Costs: It's In The Details.) The types of records you need to keep for accounting and tax purposes include the following: Business expenses Credit card statements Bank statements Annual tax returns Quarterly tax filings Payroll Inventory Sales Income Petty cash Vehicle use log Travel log Cash register tapes Credit card sales receipts Invoices Canceled checks Check stubs Other Records While this is not an exhaustive list and the types of records you will need to keep depend on your line of work, other records you should hold onto generally include the following:
Purchase orders Employment applications Emails and other business communications Inventory logs Personnel records Accident reports
Articles of incorporation Permits Licenses Trademark registrations and patents
(To learn more, read Accounting And Taxes, Like Peanut Butter And Jelly.)
Starting A Small Business: Conclusion
Starting a small business is complex, time-consuming and life-altering. There are many more things that go into running it than just providing the product(s) or service(s) that your business offers, however. You'll also be responsible for your business's finances, protecting your business and personal assets, keeping your business legal, paying taxes, keeping records, managing employees and more. If you understand what you're doing and know how to minimize the risks and challenges, the independence, personal satisfaction and financial rewards you can achieve as an entrepreneur can make starting a small business the best decision you'll ever make. (Make your dream a reality. Find out what you can do to reach this financial goal, see 9 Tips For Growing A Successful Business, and How To Make A Million In Your Small Business.)