Among a growing number of Millennials, there is a real desire to become an entrepreneur, and a belief that starting a business can be a way to attain both independence and wealth. Yet too many people put their personal finances at risk to launch a business, but I believe it can be done without sabotaging your financial future.
I’m a fan of the show ‘Shark Tank’ because I think it inspires many to think seriously about starting a business. Yet while “Shark Tank” makes it seem easy, successful entrepreneurs will tell you how hard it is. A business failure can become dicey when an entrepreneur takes on too much debt, taps personal or family savings, and later needs to declare bankruptcy.” In fact, many new businesses don’t pan out. According to the Small Business Administration (SBA), only half of business start-ups survive more than 5 years.
While I would never want to discourage anyone from pursuing a dream, I do think it’s possible to reduce the personal finance risks of a business start-up by making smart choices. Here are some tips:
Delineate between business and personal assets.
Set up a limited liability company (LLC) and separate bank account. Not only does this keep a clean line between business assets and your personal or family assets, it can help reduce your personal liability and make tax compliance simpler.
If you tap your savings, leave yourself a cushion.
According to the SBA, the number one source of financing for new businesses is personal assets/savings.1 Most entrepreneurs pour some of their own money into a new business. If the business takes off, that can be a great investment. While you may believe your business will be a sure thing, it’s important to set parameters around how much of your personal savings you’re willing to contribute. In other words, don’t tap it all.
Be careful about using retirement accounts.
For many young people, retirement accounts can be some of their only savings, and it can be tempting to use those accounts believing there will be time to replenish them once the business succeeds. Some qualified retirement plans like 401(k)s allow participant to borrow from the account. Keep in mind, however, that you must pay the loan back within a stated timeframe. If you fail to do so, it will be treated as a distribution from your account and will be taxed. In addition, you may face a penalty for early withdrawal. Tax rules prevent borrowing from an IRA, so any withdrawal from the account will be considered a taxable distribution, and possibly a penalty as well.
Another technique gaining publicity is called “Rollovers as Business Start-ups” (ROBS), which are arrangements in which business owners use their 401(k), IRA or other retirement funds to fund a new business without triggering taxes. The IRS has made it clear it’s watching these transactions for abuse, so be sure to follow the rules very carefully if you choose this approach.
Don’t build your business on personal debt.
Financial planners generally recommend limiting your total monthly debt service payments (including housing and personal debt) to 36% of your monthly gross income. If you personally borrow money for your business and it fails, you may have to declare personal bankruptcy.
Don’t rely on credit cards if you need to finance the business.
It can be easy when cash flow is slim to charge expenses to your business credit card. But most commercial credit cards charge significantly higher interest rates than other sources of credit such as a business line of credit. In addition, many small businesses owners need to provide a personal guarantee when applying for a business credit card. So even if you’ve kept your business and personal accounts separate, if your business fails, you may be personally responsible for the credit card debt.
Consider funding your business with money from outside investors or family members.
While most entrepreneurs don’t want to give away a slice of their dream, it can be a way to avoid taking on personal debt and it may force greater discipline as you will have to report to investors.
Take advantage of small business loans.
These funds can be attractive sources of financing. If you’re a woman or minority investor, take advantage of special loans that might be available to you.
Don’t forego insurance.
Many married entrepreneurs rely on their spouse to provide health insurance coverage for the family, but if that isn’t an option, buy a personal policy. A severe illness or accident while uninsured can devastate your finances. As a business owner, consider any specialized insurance coverage you may need to protect those interests.
Keep a fall back.
If you are an attorney, CPA or other professional, be sure to maintain your license, and give careful consideration to continuing to work full or part time while your business is getting started. Once your business does become your full-time pursuit, it’s important to keep up your skills in case you ever wish to return to your old line of work.
Know when to throw in the towel.
There may come a time when, despite all your hard work and effort, it becomes clear that a business is not going to be able to support you and your family. Identify goals upfront to define business success, and on the flip side, failure. Once it is clear that the business will not be successful, accept that and move on.
While not easy, launching a successful business can be tremendously fulfilling and in time, financially rewarding. When your business does start to take off, be sure to dedicate time to rebuilding your personal finances, if necessary, and working with a team of experts who understand your vision and can help ensure you are on track to meet your goals for the future.
Tim Steffen is Director of Financial Planning for Baird’s Private Wealth Management group. In this role, he meets with clients and prospects to discuss their financial and estate planning needs, as well as serves as an income tax specialist for Baird Financial Advisors. Tim also supports Financial Advisors in a marketing and training capacity, helping them understand the benefits of using financial planning in their business and educating them on planning techniques.