Starting your new business on the right financial foot

Despite widespread business closures, entrepreneurs are proving a pandemic is a good time to start a new business. What should they do different to ensure they don’t fail?
Feature Starting New Business On Right Foot Panel

2020 was a tough year for owning a business, and yet there’s reason for optimism that Americans’ entrepreneurial spirit isn’t dead.

Published in September 2020, Yelp’s Local Economic Impact Report noted that approximately 165,000 businesses listed on the website had closed their doors due to the pandemic and nearly 100,000 of those businesses reported that the closures were permanent, a startling statistic since we know the fourth quarter of 2020 likely saw many more businesses go dark for good.

However, according to the U.S. Census Bureau Business Formation Statistics, over 3.2 million new business formation applications were submitted through Sept. 30, 2020 — a 27% increase over the first three quarters of 2019. So, while the pandemic has closed tens of thousands of doors, it’s also been an opportunity for millions of new ones to open.

Of course, financial literacy is crucial to the success of these new companies, especially if they want to see a different outcome from the businesses that succumbed to the effects of the pandemic. IB recently spoke with Martha Sullivan, president of Provenance Hill Consulting LLC and Exit Stage Right columnist, about some simple steps to help business owners start off on the right foot or get back on track when things start to go awry.

To begin, what steps can business owners take to better ensure they’re setting themselves up for success?

Sullivan Martha 2016

Martha Sullivan

“There are four critical success factors, in my opinion, that new and for that matter existing business owners must have in place for getting started well. Two are financial and the other two boil down to mindset.

“The two financial drivers are capitalization and profitability. First and foremost, adequate capitalization is king. This means having adequate financial resources on hand or readily accessible to keep the lights on and the machines running for the foreseeable future. For the new entrepreneur, seed capital traditionally comes from personal savings, family, and friends. He or she also needs sufficient resources available to keep putting food on the table at home while the business navigates the lean times that occur during startup and the economic ups and downs every business faces.

“The second financial factor — profitability — seems obvious and it is. Unfortunately, obvious isn’t the same as easy or automatic. Achieving profitability requires discipline and information. There must be a clear understanding of the direct and indirect costs that go into the product or service. Research and analysis are required to know what pricing will be most effective and how far the market can be pushed. Systems and feedback loops must be established to monitor and dynamically control costs and maximize profit. This can be a blind spot for many.

“The other two success factors are mindset driven. As discussed in my column on these four drivers, the vision for the business and what the entrepreneur’s end goal is in having their own business sets the tone for all of the decisions she makes going forward. For example, the choices she’ll make about marketing, infrastructure, and operations are very different if she dreams of creating an empire to sell in five to 10 years compared to if her goal is to have a steady enough income to provide for her family. Once she’s clear on that vision, she can move forward to create a business plan to guide her.

“Lastly, there is a difference in the mindset of someone who becomes a business owner because it suits their lifestyle and a business owner that sets out to create a business that will have transferable value. Lifestyle businesses tend to be highly dependent upon the owner because it fits his lifestyle and what he wants to get from the business. Those companies with transferable value build systems to make sure that the business is not dependent upon him. Again, like beginning with the end in mind, mindset becomes the domino at the head of the line, propelling all the other decisions made. Every successful entrepreneur and owner recognizes the importance of actively managing their mindsets.”

What’s one business process a successful business owner can’t do without?

“The most valuable feedback loop for any business owner are the financial accounting and reporting systems. Coming from a CPA, that may sound incredibly biased, and it probably is. However, having been a controller, CFO, and COO, as well as consultant to hundreds of businesses, it’s a bias born from seeing disappointment, frustration, and financial loss that could have been avoided had the business owner taken this one feedback loop more seriously.

“Let’s go back to the first critical success factor — capitalization. To know if you have enough capital to cover the foreseeable future, you have to know what you’ve been burning through, what you expect to go through, and why. You must know what your sales and margin trends are now, predict what they will be going forward, and, again, be able to answer why. The financial and accounting systems are a treasure trove for that information.

“Beyond capitalization, the financial statements are the night vision goggles over how your strategic and tactical moves are faring in the field. Good financial analysis tells you which products are delivering the most value to the bottom line or are serving as a lead magnet for driving up the overall average sale. Strong enterprise accounting systems reveal which customers are your most profitable and which are sucking the bone dry. Lastly, these are the systems that provide the feedback on your operations as well as your product designs so you can make crucial decisions around whether to make or buy and the cost-quality trade-off.

“Financial statements may be intimidating for some, comfortable for others, or simply mysterious. They can be demystified through working with a coach and integrating them into the language of the company. That’s how the owner and her team can truly leverage and unleash the power of the loop.”

So, assuming a business owner has those sound financial accounting and reporting systems in place, how might they still find themselves in trouble?

“You can be making money but not have any. It’s not uncommon that sales, profits, and net income are going great guns, but the company is cash poor. How does that happen?

“When I see this with my clients, it is usually because the balance sheet is being ignored. Most business leaders focus on the income statement, sometimes referred to as the “P&L,” or profit-and-loss statement. It is the easiest of the three financial statements an accountant prepares to understand. The P&L is intuitive — this is what I sold, this what it cost, and this is what is left over. The other two statements, the balance sheet and the statement of cash flows, are harder to get your mind around. The three reports, however, are tightly bound. Looking at one of them alone is like reading the liner notes and never watching the movie or reading the book, but at much higher stakes.

“The connection between them, and in particular, between the income statement and the balance sheet, is not well understood by many business owners. This is where the trouble begins. For a simple example, when a sale is made on credit, two things happen. The sales are recorded on the income statement as revenue and, at the same time, the amount that has yet to be collected goes on the balance sheet as accounts receivable. Until that sale is collected, there is no cash coming in. Meanwhile, cash is out the door as you have to pay your employees and your suppliers.

“Another way this often occurs is when investing in equipment or making purchases at year-end to minimize taxes. These purchases may not show up on the income statement in the same way they show up on the balance sheet. The income statement shows profit, but you’ve spent the cash.

“To effectively manage and grow a company, the income statement, balance sheet, and cash flow must be managed as a whole. This may mean working with an advisor to help enhance your understanding around these tools and how to best leverage them.”

Wouldn’t it make sense though that if there’s one area to focus most on, it’s profit? If you’re making money, the business should be a success, right?

“One of my favorite sayings from a friend and colleague, Chris Snider of the Exit Planning Institute, is, ‘If you focus only on income, you may not have value. If you focus on value, you can have both.’

“Business valuations, whether theoretical or in the market, are determined based upon the amount of reward and risk the company offers. When a business is only thinking about profit and not investing in the people and systems to run consistently into the future, there’s more risk. On the other hand, if the business is configured to grow and thrive without heavy dependence on a given party — whether owner, employee, customer, or vendor — risk is mitigated. It’s more likely that the business can go on for forever and the owners will be rewarded in kind with a higher value.

“An example of this is the solopreneur. A one-person business has immediate value to the owner in the form of the income they take from the company. It likely has little value to anyone else. That is, people are not going to be clamoring to buy the solo business because once the original owner is gone, so is the knowledge, talent, and relationships. If, as the solopreneur grows, he continues to run the show, make all the decisions, and makes only the bare minimum investments in infrastructure in order to maintain his profit, he’s done little to ensure that someone else could step in and grow the business without him. It’s still a high-risk gamble and any buyer or investor is going to discount the value.

“If, on the other hand, he does invest to make the business more transferable, this strengthens the infrastructure and ability of the company to grow and generate even more profits which, in turn, creates a more attractive and valuable company.”

We know about the importance of striking a good work-life balance as professionals, but is there a special kind of balance that entrepreneurs need to strike when so much of their business depends on them, and their livelihood depends largely on their business?

“Today’s business owner is facing a unique set of challenges that none of us have encountered before. While many have seen and survived, in one form or another, economic ups and downs, nobody has gone through them while simultaneously facing the core threat to our very being. I believe the very definition of balance is being tested.

“If we look at it from a generational perspective, 2020 forced everyone to pause and think about what is important. For the baby boomer owner, they’ve seen many ups and downs over the course of owning their company. Many got through the Great Recession in 2008 and were planning on starting to wind it down in another year or two. 2020 has shaken valuations and retirement plans. As the generation that thrived on work, many are ready for less intensity even though the present state of their company is demanding more from them.

“For Gen X owners, this generation is in the middle of it — literally and figuratively. Not only are they running and growing companies, but many are also parents of school-aged children and children of aging parents. Gen X began the demand for greater work-life balance and yet find themselves in this impossible sandwich.

“Young millennial entrepreneurs are scrappy, innovative, collaborative, and driven by purpose. They’ve witnessed corporate scandals and seen their parents suffer as corporate casualties. The goal is to have life and work integrated, and to learn, create, and make the world a better place.

“I believe that the common thread across all of these generations seeking balance is the shared recognition that balance isn’t a solo act. We need each other as sounding boards, colleagues, and coaches, as well as tools like financial literacy to allow us to achieve stable baselines that lead to dynamic growth. Business owners who create the foundation of strategic interdependency between the talent and systems in their company develop a business that is more self-sustaining without heavy dependence on the owner herself. And in that, she is able to gain more balance.”

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