One of the benefits of practicing business law for twenty years is that I can assist people based on experiences with prior clients. That is to say, my experiences with previous clients can assist my current clients in their business ventures. In my practice, I’ve represented countless clients who have set up new businesses, bought existing businesses, and sold their existing businesses. I’ve watched these business owners and seen some common financial mistakes the unsuccessful ones make. Here are three common financial mistakes that can sink a new business:
- The business is inadequately capitalized. One of the most common problems I see with unsuccessful new business owners is that they fail to bring enough funding into the business venture. As you would expect, new businesses inherently have a high failure rate. People try out new business ideas, and sometimes they fail—no matter how much money is thrown into the businesses. But interestingly, I often find buyers of existing businesses making these same mistakes of inadequate capitalization.
For example, whether you are buying or starting up a new small business, you need to have an adequate “war chest” of funds to cover start up costs, living costs, and contingencies. When I started my own firm, I used money that had been saved toward a new house to open my own business, and loaned it to the firm. My new firm was frankly not a new speculative business, and I already had existing clientele. Even with that existing funnel of business, it was amazing how deep I had to dig into funds to start up the firm—and this even prior to the firm opening! Luckily, I had a good idea of what the costs would be, and how much the company would need before it started taking care of its own costs. But often, entrepreneurs wanting to set up or to buy a small business have inadequately saved. Many times I’ve represented clients in small business purchases and sales, and often at the closing table the seller had to extend additional financing to the buyer because the buyer simply did not have enough funds in hand to both pay for the business and to pay the other start-up costs (inventory, supplies, etc.) necessary to get the business going from day one.
Create aggressive scenarios, and figure in lots of worst cases and contingencies, because almost everything is going to be more expensive than you expect it to be. Worse yet, if you’ve never started a business, you’re likely to not even conceive of certain costs you’ll have to be paying: in addition to salaries, equipment/materials, and possibly inventory (depending on your business), there will be liability insurance, premises insurance, usually workers’ compensation insurance, and all other sorts of costs. Whatever you budget for, most likely you’ll exceed.
Naïve business purchasers often make an additional financial mistake. The reason they’re purchasing a business is that they want something that is turnkey, which they do not have to create from scratch. But they often mistakenly think that a turnkey business means that it can cover is own costs of acquisition, pay for its continuation, and still earn the owner a nice living. I’ll give a couple of examples from my practice (with sufficient details changed so that they do not identify clients):
Once, I represented a man who co-owned a business with his brother. My client no longer was active in the business, but got to share the profits with his brother, who did the work and was paid a salary in addition to profits. Eventually, the brother told my client that it couldn’t keep on this way, and that he was giving his brother the choice to buy or sell, and he set a sales price at which my client could either sell to him or buy from him. My client reviewed the offer, and the company’s financials, and he saw that there was just enough money in the company’s bank account to buy his brother out. He couldn’t lose—he could buy his brother out with money already in the company, now own the company fully, and keep all of the future profits for himself. In truth, with further digging, he realized he had a very incomplete and superficial understanding of the company. While he could have used the company’s funds to buy out his brother, the company’s funds would be near empty—yet the company may need $100,000 to $200,000 of inventory to be bought as soon as he bought the company, and continually bought every month. And my client didn’t have sufficient savings to fund it himself. Furthermore, he really didn’t know how to run the company as he hadn’t been involved with it for a number of years. So even if my client did take over the company, there was no guarantee that he could keep the company’s customer base and continue with the same profitability. After some further deliberation, he realized that it was much better for both sides if he sold out to his brother, which is what he did.
A few years ago, I represented the seller who had built a nice little business for herself and had found a buyer who would give her a good retirement through owner financing. The buyer, who’d always wanted to own his own business in this field, had just enough money, he thought, to make it work if he could pay 20 percent of the price up front and have the seller finance the other 80 percent. Problem was, as he got into the transaction, the buyer hadn’t accounted for the money he would need to pay my client for the inventory of the company, in addition to the company itself. He wasn’t prepared for that and had to ask my client to finance the inventory price as well. The buyer purchased the business, and not only had to pay interest and principal on buying out the business, but interest and principal on the money he essentially borrowed for the startup inventory—and all of that is before he incurred the daily costs of running the business (with salary, expenses and the like). That lack of financial capitalization made it very difficult for the buyer during his first few years.
- Acting like a successful CEO rather than a startup entrepreneur. Another problem that has sunk new business owners—especially those who buy an existing business—is when they attempt to live a high lifestyle as the “boss” of this new venture. This mistake happens more commonly with business purchasers than with someone starting a new business. Starting a new business, the entrepreneur is often acutely aware of the shortage of funds and the need to be frugal. Business buyers, however, see the lifestyle that the seller may have led, look at the company’s financials, and immediately want to live like a big boss—making high dollar lifestyle purchases with flashy cars and larger houses. What they don’t see, however, is that these business sellers, before ever getting to live with “wealth,” often had many years of lean times and frugal living. They see the end result of the business seller’s success and want to immediately jump into that. They don’t realize that in most cases, the business seller, at the time of the sale, owned his business outright with no (or little) financing, whereas the business buyer is quite often having to finance much of the business’ purchase price. The business buyer should start off frugally and modestly.
Early in my career, I had a client sell and partially owner finance his business, who had to deal with this situation. He sold it to people who entered into it the first day wanting to live a high life. Right after buying the business, these folks also bought a new, more expensive house, as well as new luxury cars. They looked successful, and appeared far wealthier than my client, who had created a nice life for himself yet still liked to live modestly. Unfortunately, the business income, after paying my client’s loan, could not simultaneously sustain the owners’ high lifestyle, and my client eventually had to repossess the business. The second buyer he sold it to lived and acted much more frugally, and has made a success of it and paid my client off long ago.
- Having the wrong mindset when starting up or acquiring a business. The final mistake is less about something the entrepreneur did, but was more about his or her mindset. Once again, I found this mistake to be more common with business buyers than with startup entrepreneurs. Sometimes, I would represent a buyer (or if representing the seller, would speak to the buyer), and I could tell the buyer just absolutely hated where he was currently working (and in this example of mistake, the buyer was always working for someone else). This type of buyer was tired of working for someone else who got to make and keep all of the profits. Or he was sick of the long hours he was working. Or he was tired of being told what to do by his boss, who didn’t have his best interests at heart. Or all of the above. In any event, he was ready to get out of that rat race and own and run his own business.
The problem with that mindset was that the business buyer wasn’t really entering into a business for the right reasons (to create something new or different, or to provide goods or services for the benefit of the public, etc.). Instead, he was just trying to run away from a job or career he hated, and this would let him “be my own boss.” Wanting to be self-employed is not necessarily the same thing as owning and running your own business. A business is something, if done right, that can be leveraged for the owner, perhaps even be autonomous or at least partially self-driving, and in very good situations, a source of recurring revenue. Someone who really just wants to get away from his job, may really just be better cut out to be a self-employed contractor. He’s still employed, and frankly has multiple bosses (i.e. customers) rather than one boss, but he still does a job that pays him so long as he does it. Hating working for someone else, however, doesn’t equate to owning and running a successful business. And often this erroneous mindset has trapped new business owners, who realize that they now have many more burdens than they did when they were just employed by someone else.
Owning or creating a business can be exciting, and both personally and financially rewarding. But if you want to start or acquire a business, you need to do some financial planning ahead of time. Build up a war chest of funds for starting, be ready to live frugally at the outset, and most importantly, realize that owning a business can be so much more than simply working for yourself. If you need advice about starting your own business, feel free to email at wldeaton@deatonlegal.net or to call at 704-489-2491 for an appointment. We’d love to help.
