Monthly Archives: September 2009

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Starting A Business? Consider Your Legal Entity Part I

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SOLE PROPRIETORSHIP

The default legal identity for the vast majority of Freelance business consultants, the Sole Proprietorship is an extension of the owner and is not a separate legal entity.  It is possible to use a separate business name (dba = doing business as) when operating as a sole proprietor—registering with the state and /or city can be a good idea—and it’s also possible to obtain from the IRS a separate business tax ID (Employee Identification Number, or EIN) and open a business bank account, both of which are recommended.  Sole Proprietorship offers no liability protection.

The tax return filed is your own.  Since there will be business expenses,  you will file schedule C along with 1040.  Deduct the portion of your home used for business on form 8829 Use of Home for Business.  See your P & L for the numbers to use for schedule C business deductions.

Quarterly estimated taxes must be paid on the 15th of January,  June and September along with the annual filing on April 15.  Remember to file the self employment tax schedule SE in April.

SMALL BUSINESS CORPORATION

To form an S Corporation is to create a separate legal entity for your business.  You must file articles of incorporation;  write by-laws for the corporation;  and elect a board of directors and officers.  It is furthermore required that annual meetings of corporation shareholders and directors be held and  official minutes for all corporation meetings be written and retained.

To set up an S Corp. choose a name for  your business (check the name availability on your state website),  get an EIN number and call the Secretary of State’s office to receive filing instructions.  The fee is about $275, paid annually.  It is recommended that you trademark your business name.

This is a relatively new form of corporate status.  As in the standard corporation, called the C  Corporation, owners and shareholders in the business are issued stock (of one class only).

To operate as an S Corp., certain conditions must be met:  the business must be a small business, must be based in the US,  may consist of 1 to 100  shareholders only  and no shareholder can be a nonresident alien.  Business owners and the business will have limited protection from liabilities, providing that no owner has been proven to be negligent.  If an owner is proven to be personally negligent, the owner will be held personally liable.

The tax return filed is the owner’s  form 1040, along with schedule E (due April 15) plus form 1120S (due March 15).  As with any business, quarterly estimated taxes must be paid, in this case using form 1120W.  Shareholders file schedule E along with their form 1040. There is no separate corporate tax.

If this is the business entity that you elect, be careful to meet and maintain all of the conditions.  Meaning, even if you are the sole owner, you must still hold annual meetings and write and retain minutes.  Failure to meet these conditions can cause you to lose the tax advantages of  S Corp. status and the business will be re-classified as a C Corporation.

CORPORATION

Known as the C Corporation, this is the granddaddy of separate business entities.  C Corp. status offers more protection against liability than any other business entity.  If you run a large business, if your business has locations in more than one state,  if the business is expected to be very long lived  and/or if the business could be subject to significant liability,  it is worthwhile to operate as a C Corp.

Stock will be issued (of any class) and stock options can be offered.  It is generally easier to raise investment capital, as stock and/or options can be made available.  On the downside, a C Corp. has comparatively larger administrative expenses, is subject to more regulatory scrutiny and is taxed at a higher rate.

To do business in this fashion select a name for the business, obtain an EIN number and file articles of incorporation with the Secretary of State for a fee of  about $275, paid annually.  It is recommended that the business name be trademarked.

Corporation by-laws must be written and a board of directors and officers must be elected.  An annual meeting must be held for directors and officers and meeting minutes must be written and retained.

The corporation  must file the annual tax form 1120 on March 15,  plus estimated taxes on form 1120W on the 15th of  April,  June,  September and December.  Business owners file form 1040 with schedule E on April 15 plus estimated quarterly tax payments on the 15th of January, June and September using form 1040–ES.

Next week, I’ll be back with 3 more options for your business legal entity.

Kim

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Starting A Business? Consider Your Financials Part III

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Investors and lenders require significant demonstration of your ability to repay money that will be extended to your business.  Lenders will want to know when  your business can be expected to  make a profit,  so they can be shown in yet another way that you will have the ability to repay the  loan.  Investors will want to know when they can expect some ROI.

Both groups will also want to know the rationale for your financial calculations and for what purposes loan and investment capital will be utilized.  The following three statements will answer those questions.

THE BREAK EVEN ANALYSIS

The point in time when sales revenues generated equal business operating expenses is called the break even point. This is an important calculation for a new business,  perhaps  more so for those who seek funding. The Break Even analysis is also useful for established businesses that will launch a new product or service.

The B-E analysis demonstrates how much product must be sold at a given price for the business to stop losing money.  The business owner can then think about the road to profitability.  Investors will be able to think about getting paid back and eventually receiving their ROI.

Refer to your P & L  2 or 3 year projections and get the data for fixed and variable expenses and  gross revenues. Use an Excel spreadsheet to set up your B-E analysis. You will be able to experiment with different product/service prices to learn how much product must be sold at each price point to bring your business to B-E.  So now you have yet another way to help determine pricing.  Excel will also create graphs for the analyses.

FINANCIAL ASSUMPTIONS

When you have completed each of the five financial statements,  it is customary to explain your rationale for calculating things the way you did.  In a new business so much is an educated guess and in an existing business past performance points the way to the future.

Events beyond your control may occur,  an extreme example being the tanking of Lehman Brothers in September ’08 that set off our global financial crisis.  That ruined a whole lot of financial assumptions, that’s for sure!

Give an overview of the financial picture and then discuss the P & L,  Cash Flow,  Balance Sheet and B-E Analysis.  Let’em know you did your homework.  Explain and defend your decisions.

SUMMARY OF FINANCIAL NEEDS

If you seek funding for your business, then you must document for investors or the bank how you will use their money and when you will need the infusions of cash.

Will you use the loan to finance an expansion of the business? Must you buy new equipment, hire employees, increase advertising expenditures or obtain larger office space? Provide detailed info on the costs associated with making it all happen.

Creating a timetable for the roll-out will make you look very prepared, as will including references to the sections of your plan that discuss these actions.  Be convincing as you discuss how these actions will increase revenue and profits and bring in the money needed to repay the loan on time.

There are categories of financial needs:  Working Capital–money you’ll need to keep the cash flow healthy so you can do business as you should; Growth Capital–money used to expand the business and increase profits; and Equity Capital–money to be used for permanent needs, it is offered to investors who will take a risk and receive a piece of the business or dividends.

Next week we’ll take a look at options for the legal structure of your business.

Kim

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Starting A Business? Consider Your Financials Part II

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Learning to create the financial documents for your business  is a worthwhile endeavor.  Make yourself do it! You will gain a significant understanding of your business.  You will learn the art of financial analysis.

Retaining a bookkeeper and accountant to produce the monthly statements and prepare the taxes is not enough.   In most cases, they don’t know your business well enough to make important decisions.  They can tell you when to cut expenses, but they lack the hands-on overview that effective decision making requires.

That responsibility (and privilege) is yours alone.  Little by little, even those who may be intimidated by numbers can become comfortable with the process.  Every business owner is the company CFO.

THE PROFIT & LOSS (INCOME) STATEMENT

This statement demonstrates whether or not the business is making money.  It will be useful to generate  a P & L statement every month, to chart your progress and help you pay attention to what the numbers are telling you.  It is an excellent analytical and decision making tool.

Many entries from the Cash Flow statement will also be listed in the  P & L:  sales revenue generated from each product and service;  variable selling expenses such as raw materials, labor, equipment rental and advertising;  and fixed costs such as rent, office staff salaries and utilities.  When you’re financially able to do so the owner’s draw,  i.e. what you pay yourself, will be listed here as a fixed expense.

At the top of this statement, enter gross revenues (sales). There are also lines for beginning and ending inventory and cost of goods sold.  Subtract COGS from gross revenues to reveal the gross profit.

Fixed and variable  expenses are tallied and subtracted from gross profit earnings to give you the EBIT: earnings before interest and taxes.  Loan interest payments and all taxes are then entered and subtracted also, to reveal in the bottom line of the statement the net profit or loss.

THE BALANCE SHEET

The Balance Sheet shows the financial picture of your business on a particular date.  It demonstrates what the business owns and owes on a given date, usually at the end of the fiscal (or calendar) year.

The Balance Sheet is divided into 3 categories:  Assets,  Liabilities and Net Worth (owner’s equity).  All business assets such as cash in the bank,  equipment owned,  inventory, property owned, office furniture and accounts receivable are considered assets and are entered in the plus column.

Business debts and obligations, e.g. loans and loan interest payments, accounts payable and taxes owed are entered into the minus column.  Net worth emerges when liabilities are subtracted from assets.

THE QUARTERLY BUDGET REVIEW

The Pro Forma Cash Flow statement, which provides a projection of what cash can reasonably be expected to flow into and out of your business in a given month (or quarter), should be validated by a Quarterly Budget Review.   Also called the Cash Flow Statement, this document gives the actual cash flow numbers for your business and is created after the fact.

Now you can compare your best guesses to reality.  Are you over or under budget? What has been over- or underestimated? Do you need to trim or stagger certain expenses in order to pay the bills every month? How accurate were your sales projections? Moreover, how much are you spending to make the sale?

Needless to say it will benefit you to trim expenses wherever practical and control COGS by locating the lowest cost wholesalers and raw materials sources, to free up cash so you can comfortably pay the bills each month,  pay down business debts and  perhaps  allocate money for useful promotional and advertising campaigns. You will also want to take that owner’s draw as soon as possible!

We’ll conclude the money portion next week with a look at what investors and lenders will also want to see.

Kim

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Starting A Business? Consider Your Financials Part I

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So now we do the math. You will attach actual numbers to those sales projections, advertising strategies and monthly operating expenses. You will add up the items on your wish list and learn what you can and cannot afford to do.

You will see where adjustments must be made. You will develop a budget for the project,  devise a plan to finance it and greatly improve your chances of launching and sustaining a successful business. You will make your dream come true!

We’ll examine five financial documents:  Pro Forma Cash Flow;  Profit & Loss;  Balance Sheet;  Quarterly Budget Review and Break Even Analysis.  We’ll also take a look at the Financial Assumptions Summary and the Summary of Financial Needs, which are required for those who seek investors or a lender.

THE PRO FORMA CASH FLOW STATEMENT

This is the monthly (or quarterly) budget for the business.  If you run a household,  you already know how to do this.  The statement documents the expected ( projected) money that will flow into and out of your business. You as the entrepreneur will learn how much capital investment your business will need to keep the doors open and the products available for customers to purchase.  Investors and lenders will know if there is enough money to operate the business and if your business is worthy of a loan.

Accounts receivable are what customers owe you as payment for services provided by your business or payment for products sold.  Invoice= paycheck—with the important caveat that some customers will not pay you on time and a few will not pay you at all.  Accounts payable are the bills the business must pay each month.

At the risk of sounding painfully obvious, make sure that you have a very good chance of bringing in enough money each month to cover the bills, at least after doing business for 18-24 months.  Maybe this means you can’t give up your day job just yet.

If your day job is gone, then expect to dip into savings or convince friends and family to help you float the venture.  I will caution you that when it comes to friends and family, money can change the relationship, sometimes not for the better.

Refer to your marketing plan before you begin the cash flow statement.  Look at your advertising calendar and your desired ad campaigns, products that must be shipped, required travel to see clients, etc.  Determine the selling, or variable,  expenses.  These change whenever sales volume increases or decreases.

Labor is a variable expense, as it is tied to the production of what will be sold.  If you plan to open a restaurant and hire a chef, that employee is labor since he/she produces  the product.

Get a firm grip on your Cost of Goods Sold (COGS), meaning the wholesale price or the cost of raw materials needed to produce your product.  An intangible product or service also has a COGS— time and talent.  Knowing COGS helps you determine a mark-up, or profit margin, that guides your pricing strategy.  The objective is to not only cover production costs but also to generate money to sustain business operating costs and you as well.  COGS impacts pricing, which impacts  sales projections.

Fixed expenses are administrative.  They don’t change much month to month.  Rent, utilities, insurance, office supplies and wages to non-production employees (e.g. the sommelier at your restaurant) fall into this category.

New businesses producing the first few months of Pro Forma Cash Flow statements will be documenting start up costs.  If start up costs are too heavy, trim or stagger expenses wherever practical.

Quarterly tax payments,  loan payments,  loan money received and planned inventory purchases  are also documented in Pro Forma Cash Flow.  In other words, whatever you expect to spend that month and whatever you expect to sell that month,  document in this statement.

At the bottom of Pro Forma Cash Flow there is a line called Ending Cash Balance. Your mission is to have that number be positive and greater than zero.

If the numbers show that expenses will be very heavy,  do not even think about increasing your sales projections to disguise a cash shortfall! Unfortunately,  many entrepreneurs inflate projected sales revenue.  That practice will take you straight to cash flow hell when the projected accounts receivable do not materialize.  I can assure you that the accounts payable will materialize.

Your best option is to dial back on certain costs.  Consider less glamorous product packaging,  lower cost advertising,  lowering the COGS by finding another source or using less costly raw materials, or renting cheaper office space.

Nest week, we’ll examine the P & L and the Balance Sheet.

Kim

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Starting A Business? Consider Your Marketing Strategy Part III

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Even if you will not seek financing for your business and the marketing plan is for your eyes only, you will thank yourself many times over if you take the time to thoroughly research and account for all aspects of marketing, especially sales expectations for your products and/or services.  Make sure that you  understand  exactly how you will  make sales contact with prospective customers.  In your plan, note whether your business will sell primarily  B2B,  B2C  or  B2G.

THE SALES STRATEGY–PROJECTIONS

Sales is the tactical manifestation of marketing.  The theories of marketing are brought down to earth to make contact with the customer and will be validated (or invalidated) by the sales revenue generated.

When planning a new business venture it will be necessary to make sales projections (also called forecasting), ideally for 36 months into the future, to give yourself an idea of the revenue potential of your business.  It’s sort of like fortunetelling, but there are resources available to help you make a reasonable estimate.

Marketresearch.com gives current industry profiles and other data, covering 16,000 lines of business in 300+ markets. You’ll need to become a registered user;  some (but not all) info is free.  Another excellent source for business data is Boston Public Library’s Kirstein Branch. You can access certain info online at bpl.org and most is free.

Example:  in your business, you are the only sales person during the first year.  If sales are promising, you may decide to hire 1-2 sales people in year two and maybe another 1-2 more sales reps in year three.

There is data that gives the average sales revenue per full time sales representative in nearly every industry. That data will allow you to chart your expected gross income for the year, based on the number of people selling for you.

However, bear in mind that a new business is unlikely to achieve the benchmark figures during the first 3-5 years of operation.  Remember also that gross revenue is not net revenue—there are expenses associated with selling like salaries, product brochures and office supplies.

Competitive intelligence data can help confirm the accuracy of your sales projections.  However,  Freelancers and those competing with privately held companies will not be able to ascertain how much revenue is historically generated yearly by those competitors since the data is not public.

What I’ve discussed here is known as the Comparative Method of projecting sales.  It is generally more useful to project for new businesses using this method. There is also the Build-up Method, where the entrepreneur identifies all likely revenue streams and then estimates the dollar volume that can be extracted from each source in a given month (or quarter).  The Build-up Method tends to work best for businesses that have been up and running for a few years and therefore have a sales history and documented revenue streams.

Finally, consider the impact of  sales trends for your industry (meaning consumer demand) and the relative strength of the local and regional economies on your products/services.   Sales projections will never be 100% accurate.  It will be wise to keep your forecasts conservative.

THE SALES STRATEGY–CUSTOMER CONTACT

How the business owner makes contact with prospective customers will be governed by a number of factors, one of the biggest being is this an online business or is it in real time?

If  you expect to sell online, be sure to have a website with a good shopping cart set up and secure credit card processing.  Your website will function like an ambassador and an employee,  so create  it with respect. The site must communicate your brand very well, must download quickly every time and must be user friendly.  A content management system will allow you to keep the site updated yourself.

Driving traffic to the site will be your #1 job and search engine optimization will be critical.  As was suggested in a  comment to last week’s posting, internet discussion groups are a very useful way to connect with customers and create buzz.  They are a great way to drive traffic to your website.

Catalogues do double duty, allowing customers to order by telephone or the website. They are expensive to produce (product photography is costly) and print, but they still catch the customer’s eye and are widely used by the likes of LL Bean and Staples. To the customer a good catalogue is a keeper, so you don’t have to print more than once a year.  Get a toll free phone number for customer convenience.

Next, decide whether the best way to sell to customers will be face to face or by telephone.  What is traditional for your business, meaning what do competitors do? Of course, you can create your own style.  Your sales may occur primarily by telephone, but a visit to prospects to introduce yourself to decision makers and gatekeepers can be a wonderful way to separate yourself from the pack and develop relationships.

Other selling methods include bid submission (e.g. the trades or selling to the government), referral arrangements and inclusion on preferred vendor lists (e.g. caterers and florists  at a function space).  For some businesses, two or more customer contact methods will be used to generate sales.

Next week we’ll start talking about money.

Kim